Recently, I read over 20 of Buffett’s letters to this investors. Those who’re interested in the insurance business will find these even more fascinating than I did. Below are my notes from the letters by topic.
- Directors are often useless. They can be useful when there’s a controlling shareholder who does not participate in management.
- Also, it is dangerous for CEOs to predict revenue growth rates. Not only that this lends to optimism bias, but also makes the CEO more likely to commit fraud.
Earnings: Simply by retaining and reinvesting earnings, managers can report earning increases. We must focus on RoIC improvement. Companies that have higher return on their net tangible assets need to invest less in their tangible assets to get the same amount of earnings–this is very important in inflationary environments. The traditional wisdom holds that we should invest in businesses laden with natural resources, plants & machinery, but asset-heavy businesses generally earn low rates of return that barely provide enough capital to fund the inflationary needs of the business with little left over for real growth and dividends. Growing businesses have both working capital needs that increase in proportion to sales growth and significant requirements for fixed asset investments.
Owner Earnings: Income + non-cash charges – AVERAGE Capex. If all U.S. corporations were to be offered simultaneously for sale by the bankers, governmental projections of national plant and equipment spending would decrease by 90%!
Goodwill: Economic goodwill is radically different from accounting goodwill. Accounting goodwill decreases over time, while economic goodwill such as that endowed by brand-name recognition increases over time, at least at the rate of inflation if not more for businesses with franchise-like properties.
D&A: Often, managers and Wall St equate depreciation and amortization. With rare exceptions, depreciation is a real cost of doing business, but amortization of economic goodwill does not often reflect reality.
Leverage: BRK gets low-cost low-risk leverage from two items–deferred taxes and “float” from insurance.
Acquisition: Rarely do acquisitions deserve premiums. The rare cases have franchise-like characteristics: can raise volume without impairing sales/market share, and only require incremental capital investment to increase both. The other more rare scenario is when there’s a truly extraordinary manager who can unlock hidden value. Acquisition of a controlled company offers two advantages–one, managers are rarely good allocators of capital, and two, taxes.
Diversification: If you’re a know-something investor and understand business economics, and can find 5-10 sensibly priced investments, diversification makes no sense. BRK stays put with an investment and views that the stock market is a place where money is moved from active to the patient.
Institutional Imperative: (a) business will resist change, (b) corporate projects and acquisitions will materialize to soak up available funds, (c) behavior of peer companies will be mindlessly copied.
Federal Debt: The “investment income” account of our country – positive in every previous year since 1915 – turned negative in 2006. Foreigners now earn more on their U.S. investments than we do on our investments abroad. In effect, we’ve used up our bank account and turned to our credit card. And, like everyone who gets in hock, the U.S. will now experience “reverse compounding” as we pay ever-increasing amounts of interest on interest.
Institutional Investors: Frictional costs of all sorts may well amount to 20% of the earnings of American business. In other words, the burden of paying investment managers may cause American equity investors, overall, to earn only 80% or so of what they would earn if they just sat still and listened to no one.
Books recommended in the letters that I read:
Theory of Investment Value by John Burr Williams
The Great Crash by Ken Galbraith
Take on the Street by Arthur Levitt, Jr.
Bull! by Maggie Mahar
The Smartest Guys in the Room by Bethany McLean and Peter Elkind
In an Uncertain World by Bob Rubin
Poor Charlie’s Almanack by Charlie Munger