In the annual letter (this year was the 50th) sent February 28 to Berkshire Hathaway (BRK.A) shareholders, Chairman Warren Buffett relates how the company performed in the prior year, explains the company’s strategies, provides some advice to investors in general (we pulled out some of those prescriptions in Warren Buffett’s 8 Warnings for Investors) and this year even addresses the succession plan at Berkshire (which long-time Buffett partner and Berkshire Vice Chairman Charlie Munger explored in this article).
Along the way, Buffett often provides pithy comments about what constitutes a good investment and what doesn’t, yielding definitions of key investing principles in his homespun way. He also shares his unvarnished thoughts about the difference between Berkshire’s business philosophy and that of much of Wall Street.
Below we pulled out five investing definitions—some with clear implications for advisors—that were tucked away in this year’s letter to Berkshire Hathaway shareholders.
Definition 1: What Makes a Good Investment?
At both BPL [Buffett Partnership Ltd.] and Berkshire, 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.
Definition 2: What Makes a Company an Attractive Acquisition (and What Doesn’t)?
…Marginal businesses purchased at cheap prices may be attractive as short-term investments, they are the wrong foundation on which to build a large and enduring enterprise. Selecting a marriage partner clearly requires more demanding criteria than does dating.
Too often CEOs seem blind to an elementary reality: The intrinsic value of the shares you give in an acquisition must not be greater than the intrinsic value of the business you receive.
I’ve yet to see an investment banker quantify this all-important math when he is presenting a stock-for- stock deal to the board of a potential acquirer. Instead, the banker’s focus will be on describing “customary” premiums-to-market-price that are currently being paid for acquisitions – an absolutely asinine way to evaluate the attractiveness of an acquisition – or whether the deal will increase the acquirer’s earnings-per-share (which in itself should be far from determinative). In striving to achieve the desired per-share number, 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.
I can promise you that long after I’m gone, Berkshire’s CEO and Board will carefully make intrinsic value calculations before issuing shares in any acquisitions. You can’t get rich trading a hundred-dollar bill for eight tens (even if your advisor has handed you an expensive “fairness” opinion endorsing that swap).
Definition 3: What Is Investing?
Think back to our 2011 annual report, in which we defined investing as “the transfer to others of purchasing power now with the reasoned expectation of receiving more purchasing power – after taxes have been paid on nominal gains – in the future.”