The Essays of Warren Buffett - Lawrence A. Cunningham

The Essays of Warren Buffett: Lessons for Corporate America is a collection of excerpts from Berkshire Hathaway’s annual reports. I was delighted to stumble upon it, as I had planned to read Berkshire’s annual reports myself. The book synthesizes and organizes decades of reports into a more digestible format. Summarizing it concisely will be quite challenging.

After reading it, I finally feel I understand what it takes to invest like Warren Buffett and Charlie Munger. The path seems tedious, but it is immensely rewarding, both intellectually and, hopefully, financially.

Key Takeaways

Don’t base your analysis on expected price changes; that’s speculation.
Forming macro opinions based on the news is a waste of time; it only clouds your vision with confirmation bias.
“There is seldom just one cockroach in the kitchen.”
Work with honest people.
Don’t take accounting at face value.
Stick to what’s simple and within your circle of competence.
There aren’t that many great opportunities in a lifetime, when you find one, swing hard.
Be greedy when others are fearful and fearful when others are greedy.
“What is smart at one price is stupid at another.”

Governance

Good Managers

Good managers are:

Owner-oriented
Honest in communication and don’t hide problems
Able to work in the right direction without needing rigid rules (as long as they’re the right people)

Pay special attention to the CEO. This role differs from others for three key reasons:

Performance standards are usually subjective and easy to manipulate, making it hard to assess the CEO’s performance.
The CEO has no superior.
The senior role cannot be fully attributed to the board, especially since the CEO usually has many allies on it.

Aligning the Interests of Owners and Managers

Traditional solutions have included:

Stock Options for Management: Proposed as a way to align management with shareholder interests.
Greater Emphasis on Board Processes: Designed to enhance board oversight of CEO performance.
Separating the Roles of Chairman and CEO: Suggested to create clearer governance and oversight.

None of these has fully solved the problem, and some have even exacerbated it.

Notes on Stock Options:

Stock options align incentives on the upside, but not on the downside. Once issued, they usually don’t correlate with the manager’s performance, leaving the manager without the downside risk shareholders face.
Beware of management that retains earnings to increase company value, especially if they use those earnings to buy back stocks while holding stock options.
Ensure that bonuses are tied to the manager’s personal achievements.

Buffett’s preferred solution: Find a CEO who will perform well despite a poor structure.
Having an outstanding board also helps.

Full and Fair Disclosure

Be cautious of companies with weak accounting practices.
- If stock options aren’t counted as expenses or if pension plan assumptions are unrealistic, be wary. “There is seldom just one cockroach in the kitchen.”
- Promoting EBITDA as a key metric is misleading. It implies that depreciation isn’t a real expense, which is nonsense. Depreciation is crucial because it represents an expense that occurs long before it generates revenue.
Unclear footnotes often indicate untrustworthy management. If a footnote is confusing, it’s likely because the CEO doesn’t want you to understand it.
Be suspicious of companies that emphasize earnings projections and growth expectations. Business is rarely a smooth, predictable environment.

Boards and Managers

Characteristics of Effective Board Members

Business savvy
Genuine interest in the job
Owner-oriented

Three Types of Board Situations

No Controlling Shareholder (Most Common)
- The board should act in the long-term interests of shareholders, as if there were a single absentee owner.
- Directors must be willing to replace management if it is mediocre or greedy, just as a diligent owner would.
- The board should be small, with outside members who periodically meet without the CEO to evaluate performance.
- If a director disagrees with the board and cannot persuade them, they should feel free to voice concerns to shareholders. However, addressing issues of mediocrity or overreach can be challenging in this setup.
Controlling Owner Who Is Also the Manager (Berkshire’s Situation)
- The board cannot effectively mediate between shareholders and management since the owner/manager holds the power.
- If the owner/manager is ineffective or overreaches, the board can only try to persuade them to change.
- If persuasion fails and the issues are serious, outside directors should resign to signal their concerns—one of the few tools available in such a structure.
Controlling Owner Not Involved in Management
- Outside directors are in a strong position because they can address concerns directly with the controlling owner, who can make immediate changes if convinced.
- This setup is ideal for ensuring competent, shareholder-friendly management, as the controlling owner can select effective directors and quickly correct any issues.

Logically, the third scenario is the most effective.

Berkshire’s Approach

Berkshire aims to make managers more effective by:

Eliminating ritualistic CEO activities related to the owner.
Giving managers one simple mission: Run the business as if:
1. You own 100% of it;
2. It is the only asset you and your family will ever have;
3. You can’t sell or merge it for at least a century.

“As a corollary, we tell them 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.”

Choosing the right boat

“Samuel Johnson’s horse: “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.”

“Managerial performance (measured by economic returns) is more about the business you are in than how well you manage it. If you find yourself in a chronically leaking boat, it’s better to change boats than to patch leaks.”

Investing

Limitations of Modern Portfolio Theory

Modern portfolio theory suggests that you can mitigate the risk of holding a stock by diversifying, and this works well in efficient markets.

Markets are not completely efficient.
Equating volatility with risk is inaccurate.

Key Takeaways from His Mentor, Graham

Mr. Market: A metaphor introduced by Benjamin Graham and popularized by Warren Buffett to describe the stock market. “Mr. Market is a fictional character who shows up every day to offer you a price at which he will either buy your stocks or sell you more shares. Mr. Market is emotionally unstable, driven by irrational moods. Sometimes he’s euphoric, offering to buy your stocks at high prices, and other times he’s pessimistic, offering to sell you stocks at low prices.”
Margin of Safety: Buy securities only when they are priced significantly below their intrinsic value. This gap between the market price and intrinsic value provides a cushion against errors in judgment or unforeseen events.
Circle of Competence: The areas or industries in which an investor has a deep understanding and expertise. Knowing your circle of competence means knowing what you understand well and, just as importantly, what you don’t.

Thoughts on Alternative Assets

Junk Bonds: Buffett rejects the “dagger thesis,” which suggests that large debt burdens discipline management. He points out that many corporations with high debt failed during the early 1990s recession, disputing claims that higher interest rates on junk bonds compensate for their higher default risk. This error, he argues, stems from the flawed assumption that historical conditions will remain the same in the future.
Zero-Coupon Bonds: Initially, zero-coupon bonds allowed borrowers to lock in high compound returns without needing immediate cash flow for interest payments. However, problems arose when weaker companies issued these bonds, unable to sustain their increasing debt obligations. Buffett notes that Wall Street often takes good ideas and turns them bad, leading to financial instability.
Derivatives: Buffett has long been wary of derivatives, warning that their complexity and the interdependencies they create among financial institutions could increase systemic risk rather than reduce it. His concerns were validated during the 2008 financial crisis. He shares his direct experience managing a derivatives business, which was fraught with challenges and took years to unwind, underscoring the dangers of these instruments.
Investment Partnerships: Buffett also discusses significant investment partnerships, such as those with Leucadia National (Berkadia) and private equity firm 3G (Heinz and Kraft merger). These essays provide insights into the complexities and negotiations involved in such partnerships, reflecting Buffett’s strategic thinking.

Arbitrage

When cash exceeds the number of good ideas, Warren and Charlie sometimes engage in arbitrage. It pays better than T-bills and allows them to wait for better opportunities. In recent years, arbitrage has mostly involved takeovers, exploiting the gap between the market price and the buy price of the acquirer before the deal is finalized.

Four questions to evaluate an arbitrage opportunity:

How likely is it that the promised event will occur?
How long will your money be tied up?
What chance is there that something better will happen—a competing takeover bid, for example?
What will happen if the event does not take place because of antitrust action, financing glitches, etc.?

“An investor cannot obtain superior profits from stocks by simply committing to a specific investment category or style. He can earn them only by carefully evaluating facts and continuously exercising discipline.”

Risk

The dictionary defines risk as the possibility of loss or injury. In finance, academics define it as volatility.

Another, more accurate perspective on risk should include:

The certainty with which the long-term economic characteristics of the business can be evaluated.
The certainty with which management can be evaluated, both in terms of its ability to realize the full potential of the business and to wisely employ its cash flows.
The certainty that management can be relied upon to channel the rewards from the business to the shareholders rather than to itself.
The purchase price of the business.
The levels of taxation and inflation that will be experienced, which will determine the degree by which an investor’s purchasing-power return is reduced from his gross return.

This perspective is not as objective as the Beta, but it’s better to be approximately right than precisely wrong. Sticking with easy cases within your circle of competence is the best approach here.

The irrationality of big funds is an advantage for us. It creates mispricing and great buying opportunities.

Lessons Learned from Mistakes and Experience

Avoid the “Cigar Butt” Investing Approach: Buying businesses at seemingly cheap prices can be misleading. If the underlying business is fundamentally weak, initial gains are often eroded by ongoing challenges. It’s better to invest in solid businesses with good long-term prospects.
Good Management Can’t Save Bad Businesses: Even excellent managers can’t overcome the inherent difficulties of a bad business. It’s crucial to invest in companies with strong economic fundamentals.
Focus on the Easy Wins: Success often comes from tackling simple, straightforward opportunities rather than trying to solve complex problems. Avoiding tough challenges is usually more profitable.
Beware of the Institutional Imperative: Organizations often resist change and make irrational decisions due to internal dynamics. It’s essential to recognize and mitigate this tendency in both management and investments.
Partner with Trustworthy People: Success is more likely when you work with individuals you like, trust, and admire. Avoid partnering with those who lack integrity, regardless of the business opportunity.
Regret Missed Opportunities: Some of the biggest mistakes are the opportunities you understand but don’t pursue. Missing these can be costly.
Maintain Conservative Financial Policies: Avoid excessive leverage, even if it seems to offer higher returns. The small risk of financial distress or disgrace isn’t worth the potential gains. Sensible actions yield good results without unnecessary risk.
Invest Your Liquid Assets in U.S. T-Bills: We don’t try to get a tiny bit more return—the extra risk is not worth it.
“An epidemic of fear or greed will forever occur in the investment community. The timing is unpredictable, and we don’t attempt to anticipate it. We just try to be greedy when others are fearful and fearful when others are greedy.”

Home Ownership and Credit Lessons

The Housing and Mortgage Crisis: The U.S. housing market collapse in 2008 was fueled by widespread irresponsible behavior across all sectors, driven by the misguided belief that home prices would always rise. This led to reckless lending and borrowing practices, where many homeowners refinanced to extract cash, fueling a consumption boom. However, this ultimately resulted in widespread foreclosures and economic turmoil.
Clayton Homes’ Sensible Lending Practices: Unlike many in the industry, Clayton Homes followed prudent lending practices. Despite its borrowers having lower credit scores, the company maintained low delinquency and foreclosure rates because it ensured borrowers only took on mortgages they could realistically afford, based on their actual income, not speculative home value increases.

Key Lessons for Future Stability:

Home purchases should be based on practical considerations, such as enjoyment and utility, rather than speculative profit.
A meaningful down payment (at least 10%) and affordable monthly payments are crucial for long-term homeownership stability.
Income verification and responsible lending practices are essential to prevent future housing crises.
The focus should shift from merely getting people into homes to ensuring they can sustain homeownership.

Capital Allocation

Share Buybacks

A company should only consider repurchasing its shares when two key conditions are met:

The company has sufficient funds—cash reserves and a reasonable borrowing capacity—that exceed its near-term business needs.
The stock is trading in the market at a price below its conservatively estimated intrinsic value.

An important caveat: shareholders need access to all relevant information to accurately estimate this intrinsic value. Without transparency, there’s a risk that insiders could take advantage of uninformed shareholders by repurchasing shares at a fraction of their true worth. Although rare, such practices do occur. More commonly, manipulation is used to inflate stock prices rather than deflate them.

In the 1970s, Warren Buffett and Charlie Munger identified companies that engaged in significant share buybacks as potential bargains—signaling that they were trading below intrinsic value and managed by owner-oriented leaders. However, be wary: if the stock is overvalued, buybacks can be detrimental to shareholders who continue to hold their shares.

My advice: Before proceeding with share repurchases, a CEO and their Board should metaphorically stand together and declare, “What is smart at one price is stupid at another.”

Finally, keep in mind that if you plan to be a net buyer of stocks in the future, rising prices are disadvantageous to your position.

Dividends and Capital Allocation

Dividend policy is a crucial aspect of capital allocation that investors need to understand.

First, it’s important to recognize that not all earnings are created equal. In capital-intensive businesses with a high asset/profit ratio, inflation requires some of the reported earnings to be reinvested just to maintain current business capacity.

There’s only one valid reason for management to retain unrestricted earnings in the company: the reasonable prospect (preferably backed by evidence or thorough analysis) that every retained dollar will create at least $1 of value for the business’s owners.

Acquisitions

Be wary of acquisitions. There are often questionable motives from management:

Animal Spirits: Managers, too, can be driven by the thrill of making deals.
Size Matters: Managers are often judged by the size of their company, and acquisitions make it bigger.
Wishful Thinking: Overestimating potential synergies.

Acquisitions are rarely as profitable as intended. Mergers are difficult, and capital allocation is seldom a strong suit of management.

Why Then Do LBOs Work So Well?

The combined value of stock and debt is much higher than the value of the stock alone due to tax effects. Debt reduces taxes, increasing the stream of earnings.
As a result, former shareholders are often paid too much to exit. In a sense, they receive part of the value enhancement created by the debt.
New owners implement strategies such as:
- Cost Reduction
- Selling off Operations: Disposing of certain operations at high prices to competitors or other companies (decided by management with shareholders’ money).

These factors, along with extreme financial leverage, benefit new owners. However, LBOs tend to drive up acquisition prices. Therefore, management teams that recognize this usually make few acquisitions.

Valuation and Accounting Distortions

Working within a range of possibilities is often the best approach. Typically, the range is so wide that it doesn’t lead to any useful conclusion, but occasionally, it does.

Intrinsic Value

Intrinsic value is the discounted value of the cash that can be taken out of the business during its remaining life.

However, the calculation is not straightforward.

Book Value

Book value is easy to calculate but has limited use and is heavily influenced by accounting principles.

In GAAP, earnings of controlled subsidiaries are fully consolidated, while minority holdings only add their dividend to the earnings.

Charlie and Warren’s approach is to ignore GAAP figures and focus solely on the future earning power of the businesses they own.

Look-Through Earnings

Earnings from subsidiaries are reported differently depending on the percentage of voting rights a company holds (GAAP).

Generally:

Over 50%: All items are detailed in the consolidated account.
20-50%: Only one line of net income is reported.
Less than 20%: Only dividends are reported.

Berkshire’s insurance businesses hold many stocks under 20%, which creates a distortion in earnings since these companies usually distribute only a small portion of earnings as dividends.

Conversely, in some companies, a large portion of earnings must be reinvested just to keep the business running. These earnings mean less to us, even if they are fully reported.

An investor’s goal should be for their portfolio to deliver the highest possible look-through earnings a decade from now.

While in the long run, the market price is the scoreboard, prices are ultimately determined by future earnings. And just as in baseball, to score runs, one must watch the playing field, not just the scoreboard.

We prefer looking at the earning rate on equity capital employed (without too much leverage or accounting gimmickry) rather than earnings per share.

Economic vs. Accounting Goodwill

Berkshire’s intrinsic value considerably exceeds its book value:

Standard accounting principles require common stocks to be valued at market value, but larger holdings are valued at the lower of purchase price or market value.
We own businesses with economic goodwill far greater than their accounting goodwill, which should be considered in intrinsic value.

It’s worth noting that Graham focused on tangible assets and rejected the notion of economic goodwill. Warren took some time to move away from this idea.

In accounting, when a business is purchased, a fair value of identifiable assets must be calculated. Any amount exceeding that value is “goodwill” in accounting terms.

For purchases after 1970, this goodwill needs to be amortized over a maximum of 40 years (the option generally chosen by management, including Berkshire’s).

We believe managers and investors should view intangible assets from two perspectives:

In analyzing operating results: Amortization charges from goodwill should be ignored.
In evaluating the wisdom of business acquisitions: Amortization of goodwill should also be ignored. Accounting goodwill is part of the cost of the acquisition and should remain so.

Owner Earnings

Owner earnings are calculated as follows: Reported earnings (a) + depreciation, depletion, and amortization (b) + certain non-cash items – (c) expenditures required to maintain the business’s competitive position and unit volume.

This last item is not reported by GAAP. Despite this, Warren considers owner earnings to be the key figure when valuing a business.

We must be cautious and check if GAAP earnings are not greater than owner earnings.

This is the case if (c) > (b).

Cash flow, therefore, can only be accurately assessed in businesses with a small (c). But for manufacturing, retail, utilities, etc., it should be regarded with caution.

Option Valuation

The Black-Scholes formula is widely used but has flaws, especially when valuing long-term options.

Accounting

Be suspicious.

Additional Resources

Berkshire’s owner manual (well worth reading): Berkshire Hathaway Owner’s Manual

The Essays of Warren Buffett – Lawrence A. Cunningham