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Warren Buffett On Buybacks, Bets And Bad Financial Practices - Highlights Of His Annual Letter

Buffett bhakts read this for his views on buybacks, bad financial practices and passive investing. 



An attendee wearing a large head in the likeness of Warren Buffett, chairman and chief executive officer of Berkshire Hathaway Inc., on the sidelines of the annual shareholders meeting. (Photographer: Daniel Acker/Bloomberg)
An attendee wearing a large head in the likeness of Warren Buffett, chairman and chief executive officer of Berkshire Hathaway Inc., on the sidelines of the annual shareholders meeting. (Photographer: Daniel Acker/Bloomberg)

Like it does every year, Warren Buffett’s annual letter to shareholders this year too offers a mix of financial wisdom, business performance reviews, investment mantras and his trademark Buffett-isms.

Bhakts of the Berkshire Hathaway chairman, often referred to as the Oracle of Omaha and recognised as a legendary investor of our times, will by now have read and memorised every word of his 29 page letter. But for the rest of you this article offers a quick glimpse at the key issues Buffett has focussed on in the letter and a few of his quotable quotes.

To Buyback Or Not To Buyback

At a time when India’s largest information technology company Tata Consultancy Services has announced a buyback, and its closest competitor Infosys is said to be considering one, Buffett’s views on buybacks are worth reading.

In the investment world, discussions about share repurchases often become heated. But I’d suggest that participants in this debate take a deep breath: Assessing the desirability of repurchases isn’t that complicated.

From the standpoint of exiting shareholders, repurchases are always a plus. Though the day-to-day impact of these purchases is usually minuscule, it’s always better for a seller to have an additional buyer in the market.

For continuing shareholders, however, repurchases only make sense if the shares are bought at a price below intrinsic value. When that rule is followed, the remaining shares experience an immediate gain in intrinsic value. Consider a simple analogy: If there are three equal partners in a business worth $3,000 and one is bought out by the partnership for $900, each of the remaining partners realizes an immediate gain of $50. If the exiting partner is paid $1,100, however, the continuing partners each suffer a loss of $50. The same math applies with corporations and their shareholders. Ergo, the question of whether a repurchase action is value-enhancing or value-destroying for continuing shareholders is entirely purchase-price dependent.
It is puzzling, therefore, that corporate repurchase announcements almost never refer to a price above which repurchases will be eschewed. That certainly wouldn’t be the case if a management was buying an outside business. There, price would always factor into a buy-or-pass decision. When CEOs or boards are buying a small part of their own company, though, they all too often seem oblivious to price. Would they behave similarly if they were managing a private company with just a few owners and were evaluating the wisdom of buying out one of them? Of course not.

It is important to remember that there are
two occasions in which repurchases should not take place, even if the company’s shares are underpriced. One is when a business both needs all its available money to protect or expand its own operations and is also uncomfortable adding further debt. Here, the internal need for funds should take priority. This exception assumes, of course, that the business has a decent future awaiting it after the needed expenditures are made.

The second exception, less common, materializes
when a business acquisition (or some other investment opportunity) offers far greater value than do the undervalued shares of the potential repurchaser. Long ago, Berkshire itself often had to choose between these alternatives. At our present size, the issue is far less likely to arise.

My suggestion: Before even discussing repurchases, a CEO and his or her Board should stand, join hands and in unison declare,
“What is smart at one price is stupid at another.”

Buffett concludes this section of his letter saying he is authorised by Berkshire Hathaway’s board to “buy large amounts of Berkshire shares at 120 percent or less of book value” which represents “a significant discount to Berkshire’s intrinsic value, a spread that is appropriate because calculations of intrinsic value can’t be precise”.

Call A Cost A Cost

While offering a review of Berkshire Hathaway’s business groups, Buffett launches into a caustic attack on some popular financial practices to dress up earnings.

Too many managements – and the number seems to grow every year – are looking for any means to report, and indeed feature, “adjusted earnings” that are higher than their company’s GAAP earnings. There are many ways for practitioners to perform this legerdemain. Two of their favorites are the omission of “restructuring costs” and “stock-based compensation” as expenses.

Charlie and I want managements, in their commentary, to describe unusual items – good or bad – that affect the GAAP numbers. After all, the reason we look at these numbers of the past is to make estimates of the future. But a management that regularly attempts to wave away very real costs by highlighting “adjusted per-share earnings” makes us nervous. That’s because
bad behavior is contagious: CEOs who overtly look for ways to report high numbers tend to foster a culture in which subordinates strive to be “helpful” as well. Goals like that can lead, for example, to insurers underestimating their loss reserves, a practice that has destroyed many industry participants.

Charlie and I cringe when we hear analysts talk admiringly about managements who always
“make the numbers.” In truth, business is too unpredictable for the numbers always to be met. Inevitably, surprises occur. When they do, a CEO whose focus is centered on Wall Street will be tempted to make up the numbers.

Let’s get back to the two favorites of “don’t-count-this” managers, starting with “restructuring.” Berkshire, I would say, has been restructuring from the first day we took over in 1965. Owning only a northern textile business then gave us no other choice. And today a fair amount of restructuring occurs every year at Berkshire. That’s because there are always things that need to change in our hundreds of businesses. Last year, as I mentioned earlier, we spent significant sums getting Duracell in shape for the decades ahead.

We have never, however, singled out restructuring charges and told you to ignore them in estimating our normal earning power. If there were to be some truly major expenses in a single year, I would, of course, mention it in my commentary. Indeed, when there is a total rebasing of a business, such as occurred when Kraft and Heinz merged, it is imperative that for several years the huge one-time costs of rationalizing the combined operations be explained clearly to owners. That’s precisely what the CEO of Kraft Heinz has done, in a manner approved by the company’s directors (who include me). But, to tell owners year after year, “Don’t count this,” when management is simply making business adjustments that are necessary, is misleading. And too many analysts and journalists fall for this baloney.

To say “stock-based compensation” is not an expense is even more cavalier. CEOs who go down that road are, in effect, saying to shareholders, “If you pay me a bundle in options or restricted stock, don’t worry about its effect on earnings. I’ll ‘adjust’ it away.”

To explore this maneuver further, join me for a moment in a visit to a make-believe accounting laboratory whose sole mission is to juice Berkshire’s reported earnings. Imaginative technicians await us, eager to show their stuff.

Listen carefully while I tell these enablers that stock-based compensation usually comprises at least 20 percent of total compensation for the top three or four executives at most large companies. Pay attention, too, as I explain that Berkshire has several hundred such executives at its subsidiaries and pays them similar amounts, but uses only cash to do so. I further confess that, lacking imagination, I have counted all of these payments to Berkshire’s executives as an expense.

My accounting minions suppress a giggle and immediately point out that 20 percent of what is paid these Berkshire managers is tantamount to “cash paid in lieu of stock-based compensation” and is therefore not a “true” expense. So – presto! – Berkshire, too, can have “adjusted” earnings.

Back to reality: If CEOs want to leave out stock-based compensation in reporting earnings, they should be required to affirm to their owners one of two propositions: why items of value used to pay employees are not a cost or why a payroll cost should be excluded when calculating earnings.

During the accounting nonsense that flourished during the 1960s, the story was told of a CEO who, as his company revved up to go public, asked prospective auditors,
“What is two plus two?” The answer that won the assignment, of course, was, “What number do you have in mind?”


Active Versus Passive Investing

In a section that spans five pages Buffett holds forth on the benefits of passive investing, a now pre-dominant trend in the U.S.

He starts by describing Long Bets - a non- profit organisation that administers long term bets - seeded by Jeff Bezos, the founder of Amazon Inc.

To participate, “proposers” post a proposition at Longbets.org that will be proved right or wrong at a distant date. They then wait for a contrary-minded party to take the other side of the bet. When a “doubter” steps forward, each side names a charity that will be the beneficiary if its side wins; parks its wager with Long Bets; and posts a short essay defending its position on the Long Bets website. When the bet is concluded, Long Bets pays off the winning charity.

Buffett then describes his 9 year old bet - that active investment management by professionals would underperform the returns achieved by rank amateurs who simply sat still. He says he wagered $500,000 that the performance, over 10 years, of a low cost Vanguard S&P fund would beat a set of at least five hedge funds.

At first there were no takers, he says, commenting with irony on the silence of “thousands of professional investment managers who have amassed staggering fortunes by touting their stock-selecting prowess” till only one man – Ted Seides – stepped up to Buffett’s challenge.

One that Seides stands to lose as in the nine years since the wager the Vanguard fund has gained 85.4 percent compared to the five competing fund of funds that have gained between 2.9 to 62.8 percent.

Buffett then makes a strong case for passive investing.

The problem simply is that the great majority of managers who attempt to over-perform will fail. The probability is also very high that the person soliciting your funds will not be the exception who does well. Bill Ruane – a truly wonderful human being and a man whom I identified 60 years ago as almost certain to deliver superior investment returns over the long haul – said it well: “In investment management, the progression is from the innovators to the imitators to the swarming incompetents.”

Further complicating the search for the rare high-fee manager who is worth his or her pay is the fact that some investment professionals, just as some amateurs, will be lucky over short periods. If 1,000 managers make a market prediction at the beginning of a year, it’s very likely that the calls of at least one will be correct for nine consecutive years. Of course, 1,000 monkeys would be just as likely to produce a seemingly all-wise prophet. But there would remain a difference:
The lucky monkey would not find people standing in line to invest with him.

The bottom line: When trillions of dollars are managed by Wall Streeters charging high fees, it will usually be the managers who reap outsized profits, not the clients. Both large and small investors should stick with low-cost index funds.

Buffett then eulogises John Clifton “Jack” Bogle, the founder of the Vanguard Group and a firm believer in low-cost index funds, as a “hero”.

My calculation, admittedly very rough, is that the search by the elite for superior investment advice has caused it, in aggregate, to waste more than $100 billion over the past decade. Figure it out: Even a 1 percent fee on a few trillion dollars adds up. Of course, not every investor who put money in hedge funds ten years ago lagged S&P returns. But I believe my calculation of the aggregate shortfall is conservative.  
Human behavior won’t change. Wealthy individuals, pension funds, endowments and the like will continue to feel they deserve something “extra” in investment advice. Those advisors who cleverly play to this expectation will get very rich. This year the magic potion may be hedge funds, next year something else. The likely result from this parade of promises is predicted in an adage: “When a person with money meets a person with experience, the one with experience ends up with the money and the one with money leaves with experience.”  


Buffett-isms

Buffett describes the shift in Berkshire Hathaway’s business model over the years - “from a company obtaining most of its gains from investment activities to one that grows in value by owning businesses”. A shift “that materially diminished the relevance of balance sheet figures” he says.

As is the case in marriage, business acquisitions often deliver surprises after the “I do’s.” I’ve made some dumb purchases, paying far too much for the economic goodwill of companies we acquired. That later led to goodwill write-offs and to consequent reductions in Berkshire’s book value. We’ve also had some winners among the businesses we’ve purchased – a few of the winners very big – but have not written those up by a penny.  

He reminds shareholders that for 2015 and 2016 the company chose to retain all its earnings, reinvesting them to deliver growth.

Charlie and I have no magic plan to add earnings except to dream big and to be prepared mentally and financially to act fast when opportunities present themselves. Every decade or so, dark clouds will fill the economic skies, and they will briefly rain gold. When downpours of that sort occur, it’s imperative that we rush outdoors carrying washtubs, not teaspoons. And that we will do.  

Extolling the virtues of America’s “economic dynamism” and its market system, Buffett reiterates “Babies born in America today are the luckiest crop in history”.
He highlights that “America’s economic achievements have led to staggering profits for stockholders. During the 20th century the Dow-Jones Industrials advanced from 66 to 11,497, a 17,320 percent capital gain that was materially boosted by steadily increasing dividends. The trend continues: By yearend 2016, the index had advanced a further 72 percent, to 19,763”. And while he is certain that American companies will be worth far more in the years ahead he acknowledges there will be market traumas too.

No one can tell you when these traumas will occur – not me, not Charlie, not economists, not the media. Meg McConnell of the New York Fed aptly described the reality of panics: “We spend a lot of time looking for systemic risk; in truth, however, it tends to find us.” 
During such scary periods, you should never forget two things: First, widespread fear is your friend as an investor, because it serves up bargain purchases. Second, personal fear is your enemy. It will also be unwarranted. Investors who avoid high and unnecessary costs and simply sit for an extended period with a collection of large, conservatively-financed American businesses will almost certainly do well. 


After Buffett Who?

Warren Buffett has so far not publicly revealed who will succeed him at Berkshire Hathaway. He has said though that it will be someone from within the company. Ajit Jain, who manages the Berkshire Hathaway Reinsurance Group, has long been considered a potential candidate, especially as Buffett spares no opportunity to praise his work. As he did in this year’s letter too.

When Ajit entered Berkshire’s office on a Saturday in 1986, he did not have a day’s experience in the insurance business. Nevertheless, Mike Goldberg, then our manager of insurance, handed him the keys to our small and struggling reinsurance business. With that move, Mike achieved sainthood: Since then, Ajit has created tens of billions of value for Berkshire shareholders. If there were ever to be another Ajit and you could swap me for him, don’t hesitate. Make the trade!

To be sure, Buffett also speaks highly among others of Tony Nicely, chief executive officer of GEICO, another group company.


The Berkshire Hathaway annual shareholders meeting will be held on May 6, 2017.