AuthorRohit Chauhan

http://mba.tuck.dartmouth.edu/pages/clubs/investment/WarrenBuffett.html

Some excerpts from the Q&A

Q: In your letters you speak frequently of the importance of not over-complicating things. What are your secrets to keeping your life simple?A: When making investments, pretend in life you have a punch-card with only 20 boxes, and every time you make an investment you punch a slot. It will discipline you to only make investments you have extreme confidence in. Big money is made by obvious things. If using a discount rate of 8% vs. 10% is going to make or break an investment idea, it’s probably not a good idea. Back in 1951 Moody’s published thick handbooks by industry of every stock in circulation. I went through all of them, thousands of pages, motivated by the hope that a great idea was just on the next page. I found companies like National American Insurance and Western Insurance Securities Company that nobody was paying attention to that were trading for far less than their intrinsic values. Last year we found a steel company on the Korean Stock Exchange that had no analyst coverage, no research, but was the most profitable steel company in the world


Q: I have worked in various technologies businesses, but I understand that you do not typically invest in the technology sector. Why is that? How do you view technology as an individual and as an investor?A: Technology is clearly a boost to business productivity and a driver of better consumer products and the like, so as an individual I have a high appreciation for the power of technology. I have avoided technology sectors as an investor because in general I don’t have a solid grasp of what differentiates many technology companies. I don’t know how to spot durable competitive advantage in technology. To get rich, you find businesses with durable competitive advantage and you don’t overpay for them. Technology is based on change; and change is really the enemy of the investor. Change is more rapid and unpredictable in technology relative to the broader economy. To me, all technology sectors look like 7-foot hurdles


Q: In many of your letters you speak about the importance of looking through the windshield and not the rearview mirror. What issues do you think people today are mistakenly looking at through the rearview mirror?A: Investors are always looking for the holy grail, the next great idea that will carry performance and pension returns for the several years. Right now its ‘alternative investments’ – private equity, hedge funds, the assets that have outperformed public equities for the past five years since the tech bubble burst. There’s so much money chasing these ideas now that the returns in the future will probably not be as good. At some point, public equities will become good investments again and fewer people will be looking at them. At Berkshire, we look at a lot of “super-cat” (super catastrophe) insurance business that few firms will write. The challenge is determining when there’s a paradigm shift, when the future will no longer look like the past. It’s probable that the next hundred years of hurricane activity will not look like the past hundred years. Another example, we write a lot of D and O insurance, Directors and Officers liability. Post Enron, I feel strongly that juries will award much harsher penalties to victims of corporate fraud, etc. than they would have five years ago before the average juror watched hours of news stories about all the scandals. There’s no model that can quantify that added risk, but it’s a risk that won’t be captured looking at historical data.

My thought –  The last Q&A  throws up an interesting question for Indian investors. After 3 years of great returns, are we as investors also operating with a rear mirror view? Any thoughts ?

Dividend policy is often reported to shareholders, but seldom explained. A company will say something like, “Our goal is to pay out 40% to 50% of earnings and to increase dividends at a rate at least equal to the rise in the CPI”. And that’s it – no analysis will be supplied as to why that particular policy is best for the owners of the business. Yet, allocation of capital is crucial to business and investment management. Because it is, we believe managers and owners should think hard about the circumstances under which earnings should be retained and under which they should be distributed.
The first point to understand is that all earnings are not created equal. In many businesses particularly those that have high asset/profit ratios – inflation causes some or all of the reported earnings to become ersatz. The ersatz portion – let’s call these earnings “restricted” – cannot, if the business is to retain its economic position, be distributed as dividends. Were these earnings to be paid out, the business would lose ground in one or more of the following areas: its ability to maintain its unit volume of sales, its long-term competitive position, its financial strength. No matter how conservative its payout ratio, a company that consistently distributes restricted earnings is destined for oblivion unless equity capital is otherwise infused.
Restricted earnings are seldom valueless to owners, but they often must be discounted heavily. In effect, they are conscripted by the business, no matter how poor its economic potential. (This retention-no-matter-how-unattractive-the-return situation was communicated unwittingly in a marvelously ironic way by Consolidated Edison a decade ago. At the time, a punitive regulatory policy was a major factor causing the company’s stock to sell as low as one-fourth of book value; i.e., every time a dollar of earnings was retained for reinvestment in the business, that dollar was transformed into only 25 cents of market value. But, despite this gold-into-lead process, most earnings were reinvested in the business rather than paid to owners. Restricted earnings need not concern us further in this dividend discussion.
Let’s turn to the much-more-valued unrestricted variety. These earnings may, with equal feasibility, be retained or distributed. In our opinion, management should choose whichever course makes greater sense for the owners of the business. This principle is not universally accepted. For a number of reasons managers like to withhold unrestricted, readily distributable earnings from shareholders – to expand the corporate empire over which the managers rule, to operate from a position of exceptional financial comfort, etc. But we believe there is only one valid reason for retention. Unrestricted earnings should be retained only when there is a reasonable prospect – backed preferably by historical evidence or, when appropriate, by a thoughtful analysis of the future – that for every dollar retained by the corporation, at least one dollar of market value will be created for owners. This will happen only if the capital retained produces incremental earnings equal to, or above, those generally available to investors.
To illustrate, let’s assume that an investor owns a risk-free 10% perpetual bond with one very unusual feature. Each year the investor can elect either to take his 10% coupon in cash, or to reinvest the coupon in more 10% bonds with identical terms; i.e., a perpetual life and coupons offering the same cash-or-reinvest option. If, in any given year, the prevailing interest rate on long-term, risk-free bonds is 5%, it would be foolish for the investor to take his coupon in cash since the 10% bonds he could instead choose would be worth considerably more than 100 cents on the dollar. Under these circumstances, the investor wanting to get his hands on cash should take his coupon in additional bonds and then immediately sell them. By doing that, he would realize more cash than if he had taken his coupon directly in cash. Assuming all bonds were held by rational investors, no one would opt for cash in an era of 5% interest rates, not even those bondholders needing cash for living purposes.
If, however, interest rates were 15%, no rational investor would want his money invested for him at 10%. Instead, the investor would choose to take his coupon in cash, even if his personal cash needs were nil. The opposite course – reinvestment of the coupon – would give an investor additional bonds with market value far less than the cash he could have elected. If he should want 10% bonds, he can simply take the cash received and buy them in the market, where they will be available at a large discount.
Think about whether a company’s unrestricted earnings should be retained or paid out. The analysis is much more difficult and subject to error because the rate earned on reinvested earnings is not a contractual figure, as in our bond case, but rather a fluctuating figure. Owners must guess as to what the rate will average over the intermediate future. However, once an informed guess is made, the rest of the analysis is simple: you should wish your earnings to be reinvested if they can be expected to earn high returns, and you should wish them paid to you if low returns are the likely outcome of reinvestment.
Many corporate managers reason very much along these lines in determining whether subsidiaries should distribute earnings to their parent company. At that level,. the managers have no trouble thinking like intelligent owners. But payout decisions at the parent company level often are a different story. Here managers frequently have trouble putting themselves in the shoes of their shareholder-owners.
With this schizoid approach, the CEO of a multi-divisional company will instruct Subsidiary A, whose earnings on incremental capital may be expected to average 5%, to distribute all available earnings in order that they may be invested in Subsidiary B, whose earnings on incremental capital are expected to be 15%. The CEO’s business school oath will allow no lesser behavior. But if his own long-term record with incremental capital is 5% – and market rates are 10% – he is likely to impose a dividend policy on shareholders of the parent company that merely follows some historical or industry-wide payout pattern. Furthermore, he will expect managers of subsidiaries to give him a full account as to why it makes sense for earnings to be retained in their operations rather than distributed to the parent-owner. But seldom will he supply his owners with a similar analysis pertaining to the whole company.
In judging whether managers should retain earnings, shareholders should not simply compare total incremental earnings in recent years to total incremental capital because that relationship may be distorted by what is going on in a core business. During an inflationary period, companies with a core business characterized by extraordinary economics can use small amounts of incremental capital in that business at very high rates of return. But, unless they are experiencing tremendous unit growth, outstanding businesses by definition generate large amounts of excess cash. If a company sinks most of this money in other businesses that earn low returns, the company’s overall return on retained capital may nevertheless appear excellent because of the extraordinary returns being earned by the portion of earnings incrementally invested in the core business. The situation is analogous to a Pro-Am golf event: even if all of the amateurs are hopeless duffers, the team’s best-ball score will be respectable because of the dominating skills of the professional.
Many corporations that consistently show good returns both on equity and on overall incremental capital have, indeed, employed a large portion of their retained earnings on an economically unattractive, even disastrous, basis. Their marvelous core businesses, however, whose earnings grow year after year, camouflage repeated failures in capital allocation elsewhere (usually involving high-priced acquisitions of businesses that have inherently mediocre economics). The managers at fault periodically report on the lessons they have learned from the latest disappointment. They then usually seek out future lessons. (Failure seems to go to their heads.)
In such cases, shareholders would be far better off if earnings were retained only to expand the high-return business, with the balance paid in dividends or used to repurchase stock (an action that increases the owners’ interest in the exceptional business while sparing them participation in subpar businesses). Managers of high-return businesses who consistently employ much of the cash thrown off by those businesses in other ventures with low returns should be held to account for those allocation decisions, regardless of how profitable the overall enterprise is.
Nothing in this discussion is intended to argue for dividends that bounce around from quarter to quarter with each wiggle in earnings or in investment opportunities. Shareholders of public corporations understandably prefer that dividends be consistent and predictable. Payments, therefore, should reflect long-term expectations for both earnings and returns on incremental capital. Since the long-term corporate outlook changes only infrequently, dividend patterns should change no more often. But over time distributable earnings that have been withheld by managers should earn their keep. If earnings have been unwisely retained, it is likely that managers, too, have been unwisely retained.
Historically, Berkshire has earned well over market rates on retained earnings, thereby creating over one dollar of market value for every dollar retained. Under such circumstances, any distribution would have been contrary to the financial interest of shareholders, large or small.

I am reading the annual letters to shareholder from warren buffet again. Anyone wanting an education on investing should read and re-read these letters. Found several great quotes/ ideas which I will be sharing over a few posts.

On Temperament
“Our advantage, was attitude: we learned from Ben Graham that the key to successful investing was the purchase of shares in good businesses when market prices were at a large discount from underlying business values.  We have no idea how long the excesses will last, nor do we know what will change the attitudes of government, lender and buyer that fuel them.  We do know that the less the prudence with which others conduct their affairs, the greater the prudence with which we should conduct our own affairs”

On buying businesses
“ I’ve said many times that when a management with a reputation for brilliance tackles a business with a reputation for bad economics, it is the reputation of the business that remains intact.  After many years of buying and supervising a great variety of businesses, Charlie and I have not learned how to solve difficult business problems. What we have learned is to avoid them. To the extent we have been successful, it is because we concentrated on identifying one-foot hurdles that we could step over rather than because we acquired any ability to clear seven-footers.”

On Capital allocation
“And, despite the age of the equipment, much of it was functionally similar to new equipment being installed by the industry.  Despite this “bargain cost” of fixed assets, capital turnover was relatively low reflecting required high investment levels in receivables and inventory compared to sales.  Slow capital turnover, coupled with low profit margins on sales, inevitably produces inadequate returns on capital.  Obvious approaches to improved profit margins involve differentiation of product, lowered manufacturing costs through more efficient equipment or better utilization of people, redirection toward fabrics enjoying stronger market trends, etc.  Our management was diligent in pursuing such objectives.  The problem was that our competitors were just as diligently doing the same thing.
     Accounting consequences do not influence our operating or capital-allocation decisions.  When acquisition costs are similar, we much prefer to purchase $2 of earnings that is not reportable by us under standard accounting principles than to purchase $1 of earnings that is reportable.  This is precisely the choice that often faces us since entire businesses (whose earnings will be fully reportable) frequently sell for double the pro-rata price of small portions (whose earnings will be largely unreportable).  In aggregate and over time, we expect the unreported earnings to be fully reflected in our intrinsic business value through capital gains”

On Intelligent Investing
1. that you should look at stocks as part Ownership of a business,

2. that you should look at market fluctuations in terms of his “Mr. Market” example and make them your friend rather than your enemy by essentially profiting from folly rather than participating in it, and finally,

3. the three most important words in investing are “Margin of safety” – which Ben talked about in his last chapter of The Intelligent Investor – always building a 15,000 pound bridge if you’re going to be driving 10,000 pound trucks across it.

On Investing strategy
“     Our equity-investing strategy remains little changed from what it was years ago:  “We select our marketable equity securities in much the way we would evaluate a business for acquisition in its entirety.  We want the business to be one (a) that we can understand; (b) with favorable long-term prospects; (c) operated by honest and competent people; and (d) available at a very attractive price.”  We have seen cause to make only one change in this creed: Because of both market conditions and our size, we now substitute “an attractive price” for “a very attractive price.”
     But how, you will ask, does one decide what’s “attractive”?  In answering this question, most analysts feel they must choose between two approaches customarily thought to be in opposition:  
“value” and “growth.”  Indeed, many investment professionals see any mixing of the two terms as a form of intellectual cross-dressing.  We view that as fuzzy thinking (in which, it must be confessed, I myself engaged some years ago).  In our opinion, the two approaches are joined at the hip:  Growth is always a component in the calculation of value, constituting a variable whose importance can range from negligible to enormous and whose impact can be negative as well as positive.
     Whether appropriate or not, the term “value investing” is widely used.  Typically, it connotes the purchase of stocks having attributes such as a low ratio of price to book value, a low price-earnings ratio, or a high dividend yield.  Unfortunately, such characteristics, even if they appear in combination, are far from determinative as to whether an investor is indeed buying something for what it is worth and is therefore truly operating on the principle of obtaining value in his investments.  Correspondingly, opposite characteristics – a high ratio of price to book value, a high price-earnings ratio, and a low dividend yield – are in no way inconsistent with a “value” purchase.
     Similarly, business growth, per se, tells us little about value.  It’s true that growth often has a positive impact on value, sometimes one of spectacular proportions.  But such an effect is far from certain.  For example, investors have regularly poured money into the domestic airline business to finance profitless (or worse) growth.  For these investors, it would have been far better if Orville had failed to get off the ground at Kitty Hawk: The more the industry has grown, the worse the disaster for owners.
Growth benefits investors only when the business in point can invest at incremental returns that are enticing – in other words, only when each dollar used to finance the growth creates over a dollar of long-term market value.  In the case of a low-return business requiring incremental funds, growth hurts the investor. “