|Buffett's Letter: Corporate Finance 101|
The story of Buffett's investment expertise has been told often. Buffett the investment expert operates via the investment vehicle Berkshire Hathaway, Inc. He has been the investing world's best-known value investor and relies, as he did decades ago, on old-fashioned, traditional investment analysis, the same tools, principles and techniques he picked up when he first encountered the conventions of Graham-Dodd analysis in school. Buffett studied Graham-Dodd principles (thoroughly explained in the 1940 book Security Analysis by David Dodd and Benjamin Graham).
One way to understand Buffett's investment philosophy--his thinking, his approach, his decision-making, his proclivities, his worries, and his management of risk, cash flow and liquidity--is by digesting his annual letter to shareholders. (See 2013 Letter.) Many in the industry look forward to his annual report in the way some look forward to a holiday in the Hamptons.
They count the days until March, and they guess at what topic he will pontificate on in any given year. Recall Buffett one year, expressing disappointment in the volatility of derivatives, called them "weapons of mass destruction," although he has since employed derivatives in his business operation to a modest extent.
The letter is not a sugar-coated rambling on the performance of business divisions. It's a thoughtful argument in support of decisions the company made and will make to enhance long-term shareholder value--with special emphasis on long-term.
In any given year, the letter explains his philosophy, approach, technique, financial model, and all important decisions. The letter also evaluates bad decisions and lessons learned. Students and even old-time professionals in finance who read the letter probably learn as much about applied corporate finance and investment management than from any other current source.
Buffett writes the letter in a crisp, down-home style--with bits of humor and little flamboyance. He claims he wants to reach the moms and pops of investing, although it helps to have had a course or two in accounting, some familiarity with corporate-finance principles, and an understanding of economics. Sometimes when the business scenario he describes is complex, it helps to have an MBA. Still, Buffett does his best to simplify every investment situation he describes, reviews or analyzes and simplify concepts of shareholder value.
Note, too, how Buffett doesn't resort to fads and gimmicks in investing. Berkshire's portfolio includes companies in the following industries: newspapers, railroads, insurance, and community banks. He hardly focuses on the latest technology start-up venture, probably because he is attracted to experienced management and proven track records. His letter often attributes the success in some investments to sound, shrewd management of existing operations.
So what was on Buffett's mind this year, when the letter appeared this month?
First, in 2013, he delivered no shock-the-world message, no headline-blazing assessment of the state of capitalism, and no plea to high-frequency traders to stay clear of equity markets. He might have used his forum to do so, but didn't see a need this year.
He offered calming advice on stock investing and explored a few corporate-finance topics in depth, topics that usually get deeper attention and appreciation in an intermediate MBA finance course. Yet he presents his cases in simple, clear language.
What could be more direct than for him to say, as he did this year, that if one invested in a portfolio of stocks at the beginning of the 20th century, he would have generated a return of 17,320% by the year 2000? The comment reflects his confidence and faith in equity markets and his boundless optimism--that one who invested in 1900 was still around in 2000 to reap returns.
As a prominent value investor, Buffett devotes much space to the concept of "intrinsic value" of business enterprises--whether it's his own Berkshire corporation or the numerous businesses he manages or is considering acquiring.
"Intrinsic value" implies a lot and may mean different things to different investors. "Intrinsic value" is fundamentally the real value of a business based on expected, sustainable cash flow from operations, based on the value of certain assets, and based on the ability to manage those operations wisely, efficiently, and prudently and invest in their growth.
Buffett explained once again this year that he assesses performance of business lines (and Berkshire as a whole) by evaluating the percentage change in "intrinsic value" vs. percentage changes in the S&P stock index. Investors in Berkshire have an alternative. They can invest in the S&P index or in Berkshire. And he wants them to have a reason to prefer Berkshire over a stock index.
In the absence of a pure computation of intrinsic value, Buffett reminds his readers that he uses "book value" as a proxy for deriving intrinsic value, a grossly under-stated approximation at best. Percentage change in tangible book value is as best as possible a good approximation of percentage change in intrinsic value.
The Insurance Model
This year's letter offers an excellent explanation of the insurance-industry business model. Buffett explains the model as if the industry didn't exist and is starting from scratch. He rationalizes the insurance company as a behemoth asset manager--not necessarily a risk manager generating premiums and paying out losses. He shows how profitability dynamics depend on the precision art of pricing premiums vs. risks and the probability of losses.
Accounting gurus who gush over discussions of intangible assets (goodwill, e.g.) will fall all over Buffett's 2013 discussions of intangible assets. He explains how they arise in Berkshire's businesses. He even explains quirks in accounting rules that permit strange, unexpected amortization (expensing) of these assets (which has impact on reported earnings in some subsidiaries). He doesn't indict accounting principles or experts, but provides warnings about how intangibles can distort what might be the true, intrinsic value of a business enterprise.
In an industry that has been declining so fast for so long that nobody disputes the trend, Buffett has decided to invest in newspapers. His letter explains why newspapers will thrive in certain small communities, how they fill a niche in covering local news better than television and the Internet do, and how his portfolio of newspaper ventures will successfully combine online readers with those who will still pay for a copy at the newsstand.
In recent years, since he remarked on derivatives as "weapons of mass destruction," Buffett and Berkshire have warmed up to derivatives, if they are used as risk-management tools and not as arcane, volatile instruments of speculation. Berkshire inherited derivatives positions in some of its recent acquisitions, and the company has had to manage those exposures. In the latest letter, Buffett acknowledges how derivatives can be used properly to manage financial risk and will be used in the Berkshire organization for that purpose. Other positions will be wound down.
Dividends and Stock Repurchases
Berkshire has a majority stake in numerous companies and has large positions in the stocks of such companies as American Express, IBM, Coca-Cola and Wells Fargo. It relies on and appreciates the dividends paid out from those stakes. Yet Berkshire and Buffett don't pay a dividend, even when it has amassed substantial amounts of cash. Buffett had some explaining to do, and he takes delight in having the opportunity to do so. Foremost, he is always on the prowl of using cash on hand to find the next big acquisition, the next "elephant," as he terms it.
He, therefore, goes through a step-by-step example showing when it's appropriate to pay a dividend, when it's appropriate to buy back shares, and when it's right to hoard cash and reinvest in or acquire business operations. He all but declares that Berkshire will (a) not pay a dividend soon, (b) always consider stock repurchases if, by his calculations, the market under-values Berkshire stock, (c) always lean toward the view that he can reinvest cash in ways better than what the shareholder can do, and (d) will never issue new shares to make acquisitions.
To his credit, he makes the declaration, and then he explains it. His parenthetical statements on dividends and stock repurchases might have been his under-stated response to the current controversies at Apple, Inc., where major shareholders are currently bickering over what that company should do with billions of dollars of cash it has on hand.
And to his credit, Buffett always reminds his readers he could be wrong, even if he hasn't been most of the time.
CFN: Apple's Stash of Cash, 2012
CFN: The MBA and the CFA, 2010
CFN: The Shareholder's Letter at Financial Institutions, 2010
CFN: Jamie Dimon's Letter to Shareholders at JPMorgan Chase, 2011