Lessons for Corporate America - MI - Monitor …

1 The EssaysofWarrenBuffett: Lessons ,Arranged, ,Arranged, , 1997; .. "Value" .. ' .. ' .. ,BookValue, .. ' ,valuing businesses,andusingfinancialin-formation profitably,thewritingsarebroadinscope, , itistocorrectaninefficiencyinthemarketpl aceofideasbydisseminatingtheessaystoa 'slucidessaysisthattheprinciplesoffundam entalvaluationanalysis,firstformulatedby histeachersBenGrahamandDavidDodd, , ,accounting, 'slessonsdirectlycontradictwhathasbeenta ughtinbusinessandlawschoolsduringthepast thirtyyears, ;Buffettistheirprodi-galpupil, ,toconvincingdemonstrationsofthedeleteri ouseffectsofusingstockoptionstocompensat emanagers, ,a companywithrootsina ,whenitsbookvaluepersharewas$ ,itsbookvaluepershareisaround$20, [ holdingcompanyengagedina varietyofbusinesses, 'smostimportantbusi-nessisinsurance,carr iedonprincipallythroughits100%ownedsubsi diary,GEICOC orporation, ,homefurnishings,andcleaningsys-tems,toc hocolatecandies,icecream,footwear,unifor ms, ,includingAmericanExpress,Coca-Cola,Walt Disney,FreddieMac,Gillette,McDonald's,Th eWashingtonPost, $ busi-nessata fairprice,theytakea "double-barreledapproach"ofbuy-ingontheo penmarketlessthan100%ofsuchbusinesseswhe ntheycandosoata pro-ratapricewellbelowwhatit wouldtaketobuy100%.]

2 'sportfolio,ona persharebasis,increasedfrom$4in1965toove r$22,000in1995, $4toover$258,a , , partnershipamonghim,Mungerandothershareh olders,andvirtuallyallhis$ 'spershareintrinsicvaluebyowningallorpar tofa , ]THEESSAYSOFWARRENBUFFETT7 Berkshireretainsandreinvestsearningswhen doingsodeliv-ersatleastproportionalincre asesinpersharemarketvalueovertime. It usesdebtsparinglyandsellsequityonlywheni t receivesasmuchinvalueasit , ,asBuffettcallsthem, ,theessaysconstituteanelegantandinstruct ivemanualonmanagement,investment,finance , 'sbasicprinciplesformtheframeworkfora It istruethatinvestorsshouldfocusonfundamen tals,bepatient, 'sessays, , ,butthinkingabouthowtomakesoundinvestmen tselectionsbasedonBerkshire' 'swritingsandlearnfromthem,ratherthantry toemulateBerkshire' ' ,BuffettsaidthatIcouldbethepopularizerof Graham'sideasandBuffett' 'sintellectualgenerosityandbelievesitisa ppropriatethathepassthewisdomon, , , [ 'sforty-yearcareeranda likeitis, , ,a 'sdisclosurepracticeandtheowner-relatedb usinessprinciplessummarizedabove, ,mappinganabstractchainofcommandontoa particularbusinesssituation,accordingtoB uffett, ,honest.

3 StandardsformeasuringaCEO'sperformancear einadequateoreasytomanipulate,soaCEO' ,nooneisseniortotheCEO,sonoseniorperson' ,a ; , ,however, ]THEESSAYSOFWARRENBUFFETT9 Thebestsolution,Buffettinstructs, , ,theirinterest, ,oneofthegreatestproblemsamongboardsinco rporateAmericaisthatmembersareselectedfo rotherrea-sons,suchasaddingdiversityorpr ominencetoa , ,directorpowerisweakestinthecasewherethe reisa ,thereislittlea directorcandootherthantoobjectand,inseri ouscircumstances, ,wherethereisa ,however,isa corporationwithouta ,Buffettsays. It wouldbehelpfulif directorscouldsup-plynecessarydiscipline , , commoncharacteristic:theter-riblemanager isa ,Buffettemphasizes, If onlyshort-termresultsmattered,manymanage rialdecisionswouldbemucheasier, ,considerAlDunlap' [VoL19:1beam'sworkersandclosedorconsolid atedmorethanhalfitsfacili-ties, , , ,however,ifyourecognizethatsuperiorlong- termresultscanflowfromearningthetrustofs ocialcommunities,asBuffett' ' reversalofitsmisfortunes,notinghowimport antBerkshire'stextilebusinesswastoitsemp loyeesandlocalcommu-nitiesinNewEngland, ,buta , , , ,managementallocatesa , ,solongasaggre-gateannualdonationsarerea sonableinamount,usuallynotgreaterthan10% ,thisdemonstratesa costoftheshort-termmentalityofAmerica' ]

4 THEESSAYSOFWARRENBUFFETT11 Theplantoalignmanagementandshareholderin terestsbyawardingexecutivesstockoptionsn otonlywasoversold, ,ratherthanbysuperiordeploymentofcapitaL AsBuffettexplains,how-ever,simplybyretai ningandreinvestingearnings,managerscanre portannualearningsincreaseswithoutsomuch asliftinga ,oncegranted,stockoptionsareoftenirrevoc able,uncondi-tional, managerialculturethatencouragesowner-lik ethinking, ,butthissubjectshouldreallybeonthefront- burnerofshareholders, ,afterprofitsarereducedbya ,theyshouldberelatedtoindividualper-form ance,ratherthancorporateperformance, ,asatBerkshire,stockoptionsshouldsimplyn otbepartofanexecutive' ,ex-ceptionalmanagerswhoearncashbonusesb asedontheperform-anceoftheirownbusinessc ansimplybuystockif theywantto;iftheydo,they"trulywalkinthes hoesofowners," :itisa ,youwilldo12 CARDOZOLAWREVIEW[ :1betterbyrandomlyselectinga groupofstocksfora ' diversifiedportfolio-thatis,it formalizesthefolkslogan"don'tputallyoure ggsinonebasket.]

5 "Theriskthatisleftoveristheonlyriskforwh ichinvestorswillbecompensated, , , ,incolleges,universities,businessschools ,andlawschools,butbecame standarddogmathroughoutfinancialAmericai nthepastthirtyyears, ,thattheonlyriskthatmattersisthevolatili tyofprices,andthatthebestwaytomanagethat riskistoinvestina distinguishedlineofinvestorsstretchingba cktoGrahamandDoddwhichdebunksstandarddog ma bylogicandexperience,Buffettthinksmostma rketsarenotpurelyefficientandthatequatin gvolatilitywithriskisa ,Buffettworriedthata wholegenerationofMBAsandlDs,undertheinfl uenceofmodernfinancetheory, , silverlining:it ,norcouldmountainousotherphenomenarelati ngtothebehaviorofsmallcapitalizationstoc ks,highdividend-yieldstocks, ]THEESSAYSOFWARRENBUFFETT13emergedtosayt hatbetadoesnotreallymeasuretheinvestment riskthatmatters, ,peoplestartednoticingBuffett' ,formorethanfortyyearsBuffetthasgenerate daverageannualreturnsof20%orbetter, ,BenGraham' ,thestunningper-formancesatGraham-Newman andatBerkshiredeserverespect:thesamplesi zesweresignificant;theywereconductedover anex-tensivetimeperiod,andwerenotskewedb ya fewfortunateexper-iences;nodata-miningwa sinvolved.

6 Andtheperformanceswerelongitudinal, 'sperformance, ,modernfinanceenthusiastsstillinsistthat aninvestor'sbeststrategyistodiversifybas edonbetasordartthrowing,andconstantlyrec onfigureone' quipandsomeadvice:thequipisthatdevoteeso fhisinvestmentphilosophyshouldprobablyen dowchairstoensuretheperpetualteachingofe fficientmarketdogma; ' ,theriskthatmattersisnotbetaorvolatility , company'smanagement,products,competitors , business,thequalityandintegrityofitsmana gement, ,particularlycomparedwiththeseductive14 CARDOZOLAWREVIEW[ :1precisionofbeta,butthepointisthatjudgm entsaboutsuchmat-terscannotbeavoided,exc epttoaninvestor' " 'riskier'atthelowerpricethanitwasatthehi gherprice" ,betacannotdistinguishtheriskinherentin" asingle-producttoycom-panysellingpetrock sorhulahoopsfromanothertoycompanywhoseso leproductisMonopolyorBarbie.]

7 "Butordinaryinves-torscanmakethosedistin ctionsbythinkingaboutconsumerbe-havioran dthewayconsumerproductscompaniescompete, andcanalsofigureoutwhena hugestock-pricedropsignalsa , buffett ' ,ifnotofone'sportfolio,thenatleastofitso wner' ,BuffettremindsusthatKeynes,whowasnotonl ya brillianteconomistbutalsoa brilliantinvestor, , 'sthinkingabouta ,accordingtoBuffett,suffersfrominatten-t ionto"afundamentalprinciple:Itisbetterto beapproximatelyrightthanpreciselywrong." Long-terminvestmentsuccessde-pendsnotons tudyingbetasandmaintaininga diversifiedportfo-lio,butonrecognizingth atasaninvestor, "flittingfromflowertoflower"imposeshuget ransactioncostsintheformsofspreads,feesa ndcommis-sions, "is likecallingsomeonewhorepeatedlyengagesin one-nightstandsa romantic."Invest-mentknittingturnsmodern financetheory'sfolkwisdomonitshead:inste adof"don'tputallyoureggsinonebasket,"weg etMarkTwain'sadvicefromPudd'nheadWilson: "Putallyoureggsinonebasket-andwatchthatb asket.

8 "1997] numberofclassicworks,includingTheIntelli gentInvestor, , , 'smostprofoundcontributionsisa characterwholivesonWallStreet, , ; ,thegreaterthespreadbetweenpriceandvalue , ,emphasizinghowvaluableGraham' securityunlessthereisa sufficientbasisfor ,not-ingthatGrahamhadsaidthatif forcedtodistillthesecretofsoundinvestmen tintothreewords, yearsafterfirstreadingthat, differencebetweenprice(whatyou pay)andvalue(whatyouget),BuffettandGraha mregardit "valueinvesting" ,buttospeculation-thehopethatpricewillri se, ,Buffettnotes,bydistinguishingbetween"gr owthin-16 CARDOZOLAWREVIEW[ :1vesting"and"valueinvesting."Growthandv alue,Buffettsays, "relationalinvesting" ,describinga fewcompaniesandsticksarounda ,it wouldbesomethinglike"focused"or"intellig ent" ; ; ,traditionallyun-derstoodtomeanexploitin gdifferentpricesforthesamethingontwodiff erentmarkets,forBuffettdescribestheuseof cashtotakeshort-termpositionsina :theprobabilityoftheeventoccurring,theti methefundswillbetiedup,theopportunitycos t,andthedownsideif ,onemustguardagainstwhatBuf-fettcallsthe "institutionalimperative.

9 "Itisa pervasiveforceinwhichinstitutionaldynami csproduceresistancetochange,absorp-tiono favailablecorporatefunds, , follow-the-packmentalitypro-1997]THEESSA YSOFWARRENBUFFETT17ducingindustryimitato rs,ratherthanindustryleaders-whatBuf-fet tcallsa ' ,BuffettagaindrawsonGraham'sideastorejec tthe"daggerthesis" ,usingthemetaphoroftheintensi-fiedcarean automobiledriverwouldtakefacinga daggermountedonthesteeringwheel, flawedassumptionrecognizabletoanyfirst- ' ,ratherthanonfinancialsense,a ,forexample,Buffettshowsthattheycanenabl ea purchasertolockina compoundrateofreturnequaltoa timeenableda ,however, ,"ashappensinWallStreetalltoooften,whatt hewisedointhebegin-ning,foolsdointheend. "Theessaysonpreferredstockshowtheartofin vestingatitsfinest,emphasizingtheeconomi ccharacteristicsofbusinesses,thequalityo fmanagement,andthedifficultjudgmentsthat arealwaysnecessary, ,hetoldJimmyMaguire,thespecial-18 CARDOZOLAWREVIEW[ :1istinBerkshirestock,"Iwillconsideryoua nenormoussuccessifthenexttradeinthisstoc kisabouttwoyearsfromnow.

10 "WhileBuffettjokesthatMaguire"didn'tseem togetenthusedaboutthat,"heemphasizesthat hismind-setwhenhebuysanystockis"ifwearen 'thappyowninga pieceofthatbusinesswiththeExchangeclosed ,we'renothappyowningit withtheExchangeopen."Berk-shireandBuffet tareinvestorsforthelonghaul;Berkshire' ,whodesiretheircompany'sstocktotradeatth ehighestpossiblepricesinthemarket,Buffet tprefers shareholdergroupwitha collectivelong-term, business-orientedinvestmentphilosophy,ra therthana short-term, 'ssuggestionthata companyislikearestaurant,offeringa ' ,Buffettesti-matesthatthetransactioncost sofactivelytradedstocks-brokercommission sandmarket-makerspreads-oftenamountto10% ,andBerkshire' majorcapitalallocationissue, 'sessaysclarifythissubject,emphasizingth at"capitalallo-cationis crucialtobusinessandinvestmentmanagement ."Inearly1998,Berkshire'scommonstockwasp ricedinthemarketatover$50,000pershareand thecompany'sbookvalue,earnings,andin-tri nsicvaluehave stocksplit,andhasnotpaida ,Berkshire'sdividendpolicyalsoreflectsBu ffett'sconvictionthata company'searningspayoutversusretentionde ci-sionshouldbebasedona singletest:eachdollarofearningsshouldber etainedif retentionwillincreasemarketvaluebyatleas ta likeamount; "capitalretainedproducesincrementalearni ngsequalto,orabove,thosegenerallyavailab letoinvestors.