1965 – 2022
Warren Buffett and Max Olson
Notes
Conservative Capitalization
The present state of the money market, in which funds are virtually unobtainable for acquisition purposes, makes it imperative that we have available the liquid assets with which to consummate such acquisitions, should the hoped-for opportunities present themselves.
We retain a fundamental belief in operating from a very strongly financed position so as to be in a position to unquestionably fulfill our responsibilities.
…we will not hesitate to borrow money to take advantage of attractive opportunities.
Under all circumstances we plan to operate with plenty of liquidity, with debt that is moderate in size and properly structured, and with an abundance of capital strength. Our return on equity is penalized somewhat by this conservative approach, but it is the only one with which we feel comfortable.
Small portions of exceptionally good businesses are usually available in the securities markets at reasonable prices. But such businesses are available for purchase in their entirety only rarely, and then almost always at high prices.
…predicting rain doesn’t count, building arks does.
Charlie and I believe Berkshire should be a fortress of financial strength.
…the importance of liquidity as a condition for assured survival.
Financial staying power requires a company to maintain three strengths under all circumstances:
- a large and reliable stream of earnings
- massive liquid assets
- no significant near-term cash requirements
Retained Earnings vs. Dividends
The emphasis continues, however, to be on underwriting at a profit rather than volume simply for the sake of size. Due to our policy of retaining all earnings in the insurance subsidiaries, we have substantially augmented their capital funds.
We set no volume goals in our insurance business generally — and certainly not in reinsurance — as virtually any volume can be achieved if profitability standards are ignored.
We are not at all unhappy when our wholly-owned businesses retain all of their earnings if they can utilize internally those funds at attractive rates.
…a more appropriate measure of managerial economic performance to be return on equity capital.
…the value of those retained earnings is determined by the use to which they are put and the subsequent level of earnings produced by that usage.
The returns from passive capital (retained earnings) outstrip the returns from active capital (dividends that must be taxed and reinvested).
Logically, a company with historic and prospective high returns on equity should retain much or all of its earnings so that shareholders can earn premium returns on enhanced capital. Conversely, low returns on corporate equity would suggest a very high dividend payout so that owners could direct capital toward more attractive areas.
Other companies sell newly issued shares to Peter in order to pay dividends to Paul.
Beware of “dividends” that can be paid out only if someone promises to replace the capital distributed.).
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.
…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.
Long-term Outlook
…continue to underwrite to produce a profit, although not at the level of 1972, and base our rates on long-term expectations rather than short-term hopes.
…we recommend not less than a five-year test as a rough yardstick of economic performance. Red lights should start flashing if the five-year average annual gain falls much below the return on equity earned over the period by American industry in aggregate.
Intrinsic business value is an economic concept, estimating future cash output discounted to present value. Book value tells you what has been put in; intrinsic business value estimates what can be taken out.
Our fund-first, buy-or-expand-later policy almost always penalizes near-term earnings.
Focus on the future productivity of the asset you are considering.
Concentration in a Few
Our equity investments are heavily concentrated in a few companies which are selected based on favorable economic characteristics, competent and honest management, and a purchase price attractive when measured against the yardstick of value to a private owner.
…if their business experience continues to satisfy us, we welcome lower market prices of stocks we own as an opportunity to acquire even more of a good thing at a better price.
When we are convinced as to attractiveness, we believe in buying worthwhile amounts.
…if a fine business is selling in the market place for far less than intrinsic value, what more certain or more profitable utilization of capital can there be than significant enlargement of the interests of all owners at that bargain price?
When companies with outstanding businesses and comfortable financial positions find their shares selling far below intrinsic value in the marketplace, no alternative action can benefit shareholders as surely as repurchases.
Before looking at new investments, we consider adding to old ones.
Buffett’s decision to limit his activities to a few kinds and to maximize his attention to them.
Criteria for Investment
Our objective is a conservatively financed and highly liquid business—possessing extra margins of balance sheet strength consistent with the fiduciary obligations inherent in the banking and insurance industries — which will produce a long term rate of return on equity capital exceeding that of American industry as a whole.
We select such investments on a long-term basis, weighing the same factors as would be involved in the purchase of 100% of an operating business:
- businesses we can understand
- with favorable long-term prospects
- operated by honest and competent people
- priced very attractively
We usually can identify a small number of potential investments meeting requirements (1), (2) and (3), but (4) often prevents action.
Our acquisition preferences run toward businesses that generate cash, not those that consume it. As inflation intensifies, more and more companies find that they must spend all funds they generate internally just to maintain their existing physical volume of business.
Such favored business must have two characteristics
- an ability to increase prices rather easily (even when product demand is flat and capacity is not fully utilized) without fear of significant loss of either market share or unit volume
- an ability to accommodate large dollar volume increases in business (often produced more by inflation than by real growth) with only minor additional investment of capital. Managers of ordinary ability, focusing solely on acquisition possibilities meeting these tests, have achieved excellent results in recent decades.
We prefer:
- large purchases (at least $5 million of after-tax earnings)
- demonstrated consistent earning power (future projections are of little interest to us, nor are “turn-around” situations)
- businesses earning good returns on equity while employing little or no debt
- management in place (we can’t supply it)
- simple businesses (if there’s lots of technology, we won’t understand it)
- an offering price (we don’t want to waste our time or that of the seller by talking, even preliminarily, about a transaction when price is unknown)
One question I always ask myself in appraising a business is how I would like, assuming I had ample capital and skilled personnel, to compete with it.
…we feel that if we can buy small pieces of businesses with satisfactory underlying economics at a fraction of the per-share value of the entire business, something good is likely to happen
We can choose among five major categories:
- long-term common stock investments
- medium-term fixed-income securities
- long-term fixed income securities
- short-term cash equivalents
- short-term arbitrage commitments
If my universe of business possibilities was limited, say, to private companies in Omaha, I would, first, try to assess the long-term economic characteristics of each business; second, assess the quality of the people in charge of running it; and, third, try to buy into a few of the best operations at a sensible price.
…we prefer a lumpy 15% return to a smooth 12%.
At Berkshire, our carefully-crafted acquisition strategy is simply to wait for the phone to ring.
My own preference — and you knew this was coming — is our third category: investment in productive assets, whether businesses, farms, or real estate. Ideally, these assets should have the ability in inflationary times to deliver output that will retain its purchasing-power value while requiring a minimum of new capital investment.
Keep things simple and don’t swing for the fences. When promised quick profits, respond with a quick “no.”
Quality of the Business Trumps Quality of the Management
One of the lessons your management has learned—and, unfortunately, sometimes re-learned—is the importance of being in businesses where tailwinds prevail rather than headwinds.
“turnarounds” seldom turn, and that the same energies and talent are much better employed in a good business purchased at a fair price than in a poor business purchased at a bargain price.
…when a management with a reputation for brilliance tackles a business with a reputation for poor fundamental economics, it is the reputation of the business that remains intact.
Our goal is to find an outstanding business at a sensible price, not a mediocre business at a bargain price.
An economic franchise arises from a product or service that
- is needed or desired
- is thought by its customers to have no close substitute
- is not subject to price regulation
The existence of all three conditions will be demonstrated by a company’s ability to regularly price its product or service aggressively and thereby to earn high rates of return on capital.
Good Vs. Bad Management
…the manager of a tightly-run operation usually continues to find additional methods to curtail costs, even when his costs are already well below those of his competitors.
The primary test of managerial economic performance is the achievement of a high earnings rate on equity capital employed (without undue leverage, accounting gimmickry, etc.) and not the achievement of consistent gains in earnings per share.
Yardsticks seldom are discarded while yielding favorable readings. But when results deteriorate, most managers favor disposition of the yardstick rather than disposition of the manager.
While deals often fail in practice, they never fail in projections — if the CEO is visibly panting over a prospective acquisition, subordinates and consultants will supply the requisite projections to rationalize any price.
Investors should pay more for a business that is lodged in the hands of a manager with demonstrated pro-shareholder leanings than for one in the hands of a self-interested manager marching to a different drummer.
…secrets the Blumkins bring to their business. These are not very esoteric. All members of the family:
- apply themselves with an enthusiasm and energy that would make Ben Franklin and Horatio Alger look like dropouts
- define with extraordinary realism their area of special competence and act decisively on all matters within it
- ignore even the most enticing propositions failing outside of that area of special competence
- unfailingly behave in a high-grade manner with everyone they deal with. (Mrs. B boils it down to “sell cheap and tell the truth”.)
Failing conventionally is the route to go; as a group, lemmings may have a rotten image, but no individual lemming has ever received bad press.
What a manager must do is handle the basics well and not get diverted.
…we expect a company’s CEO to explain in his or her own words what’s happening.
Charlie and I tend to be leery of companies run by CEOs who woo investors with fancy predictions.
A single, big mistake could wipe out a long string of successes. We therefore need someone genetically programmed to recognize and avoid serious risks, including those never before encountered.
Beware of geeks bearing formulas.
Beware the investment activity that produces applause; the great moves are usually greeted by yawns.
Directors should hire a second advisor to make the case against the proposed acquisition, with its fee contingent on the deal not going through.
…we were looking for someone with a hard-to-evaluate skill: the ability to anticipate the effects of economic scenarios not previously observed.
“The other guy is doing it, so we must as well,” spells trouble in any business.
Decentralized Organization
…run on the principle of centralization of financial decisions at the top (the very top, it might be added), and rather extreme delegation of operating authority to a number of key managers at the individual company or business unit level.
A compact organization lets all of us spend our time managing the business rather than managing each other.
…the heads of many companies are not skilled in capital allocation.
We believe that any subsidiary lending money should pay an appropriate rate for the funds needed to carry its receivables and should not be subsidized by its parent. Otherwise, having a rich daddy can lead to sloppy decisions.
Size seems to make many organizations slow-thinking, resistant to change and smug.
…let me know promptly if there’s any significant bad news. I can handle bad news but I don’t like to deal with it after it has festered for awhile.
Owner’s Manual – Owner-Related Business Principles
At the time of the Blue Chip merger in 1983, I set down 13 owner-related business principles that I thought would help new shareholders understand our managerial approach. As is appropriate for “principles,” all 13 remain alive and well today:
- Although our form is corporate, our attitude is partnership. Charlie Munger and I think of our shareholders as owner-partners, and of ourselves as managing partners. (Because of the size of our shareholdings we are also, for better or worse, controlling partners.) We do not view the company itself as the ultimate owner of our business assets but instead view the company as a conduit through which our shareholders own the assets.
- In line with Berkshire’s owner-orientation, most of our directors have a major portion of their net worth invested in the company. We eat our own cooking.
- Our long-term economic goal (subject to some qualifications mentioned later) is to maximize Berkshire’s average annual rate of gain in intrinsic business value on a per-share basis. We do not measure the economic significance or performance of Berkshire by its size; we measure by per-share progress. We are certain that the rate of per-share progress will diminish in the future – a greatly enlarged capital base will see to that. But we will be disappointed if our rate does not exceed that of the average large American corporation.
- Our preference would be to reach our goal by directly owning a diversified group of businesses that generate cash and consistently earn above-average returns on capital. Our second choice is to own parts of similar businesses, attained primarily through purchases of marketable common stocks by our insurance subsidiaries. The price and availability of businesses and the need for insurance capital determine any given year’s capital allocation.
- Because of our two-pronged approach to business ownership and because of the limitations of conventional accounting, consolidated reported earnings may reveal relatively little about our true economic performance. Charlie and I, both as owners and managers, virtually ignore such consolidated numbers. However, we will also report to you the earnings of each major business we control, numbers we consider of great importance. These figures, along with other information we will supply about the individual businesses, should generally aid you in making judgments about them.
- 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.
- We use debt sparingly and, when we do borrow, we attempt to structure our loans on a long-term fixed-rate basis. We will reject interesting opportunities rather than over-leverage our balance sheet. This conservatism has penalized our results but it is the only behavior that leaves us comfortable, considering our fiduciary obligations to policyholders, lenders and the many equity holders who have committed unusually large portions of their net worth to our care. (As one of the Indianapolis “500” winners said: “To finish first, you must first finish.”)
- A managerial “wish list” will not be filled at shareholder expense. We will not diversify by purchasing entire businesses at control prices that ignore long-term economic consequences to our shareholders. We will only do with your money what we would do with our own, weighing fully the values you can obtain by diversifying your own portfolios through direct purchases in the stock market.
- We feel noble intentions should be checked periodically against results. We test the wisdom of retaining earnings by assessing whether retention, over time, delivers shareholders at least $1 of market value for each $1 retained. To date, this test has been met. We will continue to apply it on a five-year rolling basis. As our net worth grows, it is more difficult to use retained earnings wisely.
- We will issue common stock only when we receive as much in business value as we give. This rule applies to all forms of issuance – not only mergers or public stock offerings, but stock- for-debt swaps, stock options, and convertible securities as well. We will not sell small portions of your company – and that is what the issuance of shares amounts to – on a basis inconsistent with the value of the entire enterprise.
- You should be fully aware of one attitude Charlie and I share that hurts our financial performance: Regardless of price, we have no interest at all in selling any good businesses that Berkshire owns. We are also very reluctant to sell sub-par businesses as long as we expect them to generate at least some cash and as long as we feel good about their managers and labor relations. We hope not to repeat the capital-allocation mistakes that led us into such sub- par businesses. And we react with great caution to suggestions that our poor businesses can be restored to satisfactory profitability by major capital expenditures. (The projections will be dazzling and the advocates sincere, but, in the end, major additional investment in a terrible industry usually is about as rewarding as struggling in quicksand.) Nevertheless, gin rummy managerial behavior (discard your least promising business at each turn) is not our style. We would rather have our overall results penalized a bit than engage in that kind of behavior.
- We will be candid in our reporting to you, emphasizing the pluses and minuses important in appraising business value. Our guideline is to tell you the business facts that we would want to know if our positions were reversed. We owe you no less. Moreover, as a company with a major communications business, it would be inexcusable for us to apply lesser standards of accuracy, balance and incisiveness when reporting on ourselves than we would expect our news people to apply when reporting on others. We also believe candor benefits us as managers: The CEO who misleads others in public may eventually mislead himself in private.
- Despite our policy of candor, we will discuss our activities in marketable securities only to the extent legally required. Good investment ideas are rare, valuable and subject to competitive appropriation just as good product or business acquisition ideas are. Therefore we normally will not talk about our investment ideas. This ban extends even to securities we have sold (because we may purchase them again) and to stocks we are incorrectly rumored to be buying. If we deny those reports but say “no comment” on other occasions, the no-comments become confirmation.
Chubb’s annual report
The Farmer from Merna
Bull!
The Smartest Guys in the Room
In an Uncertain World
Where are the Customers’ Yachts?
A Few Lessons for Investors and Managers From Warren Buffett – Peter Bevelin
Common Stocks and Uncommon Profits
The Outsiders
The Clash of the Cultures
Investing Between the Lines
Supermoney
The Little Book of Common Sense Investing
Barbarians at the Gate