Graham covers all aspects of the investment process, including the selection of an investment target and the management of acquired holdings. His philosophy comprises analytical and behavioral principles that aim to address comprehensively the full range of issues facing any investor. (Location 411)
Graham contrasts stock in a business with a bond; the stock is a residual claim against the business, whereas the bond is geared toward the collection of interest payments. (Location 417)
We could view “Know what you are doing, know your business” [Graham, 2003, p. 523] as the first of these principles. (Location 426)
He suggests that it is advisable to purchase stock in an operation only if a reliable calculation demonstrates that the venture has a good chance of returning a reasonable profit. (Location 429)
Decisions must be based on sound calculations, not on optimistic feelings. (Location 431)
predictive and protective, or conservative [Graham, 2003, p. 364]. (Location 446)
“Those who emphasize prediction will endeavor to anticipate fairly accurately just what the company will accomplish in future years—in particular whether earnings will show pronounced and persistent growth.” (Location 446)
make sure that the “indicated present value” is greater than the market price by a “substantial margin” that could absorb future negative developments [Graham, 2003, pp. 364–365]. (Location 448)
Owing to his conservatism, in practice, Graham, when selecting companies for investment, preferred not to analyze potential targets qualitatively, or, as he thought, subjectively. (Location 452)
As Graham’s intellectual heir, Buffett also does not invest in “a lemonade stand—with potential, of course, to grow into the next Microsoft” [Buffett, 1977–2013, 1995]. (Location 456)
Importantly, Graham’s view of the present value is different from the conventional understanding of it that we are used to, and we discuss this later in the chapter. (Location 464)
is the margin of safety by which the “indicated present value” must be higher than the market price. (Location 466)
In order to ensure a sufficient margin of safety, the earnings/price ratio should be at least as high as the current high-grade bond interest rate4 (Location 468)
The higher the expected growth rate, the greater the magnitude by which the discount rate (used to value the shares) must be higher than the risk-free rate. (Location 479)
Graham’s margin of safety is sometimes viewed as a purchase at a discount to fair value (for example, see Margin of Safety: Risk-Averse Value Investing Strategies for the Thoughtful Investor [Klarman, 1991] or The Little Book of Value Investing [Browne, 2006]). (Location 483)
Stocks are riskier instruments than bonds, and therefore the returns that they deliver must be greater than the risk-free rate, and their fair price must be lower than the price calculated using the risk-free rate. (Location 487)
Graham recommends paying no more than 15 times earnings for good companies. (Location 495)
According to Robert Shiller, the average P/E throughout the history of the U.S. stock market since 1871 equals 14.5. (Location 496)
Graham recommends to calculate the P/E ratio as based on average profits over the last three years. (Location 497)
He often admits that he uses the bond rate—the risk-free rate—as his discount rate, although he argues that his investments, such as Coca-Cola, are not too different from risk-free, (Location 500)
He also defines his margin of safety indirectly. (Location 503)
The CAPM describes the risk level associated with an asset as a function of its price fluctuation (through the beta coefficient). (Location 513)
Buffett believes that investment risks and, therefore, investment mistakes are driven by lack of knowledge about the specific company or the industry as a whole. (Location 515)
Current statistics on acquisitions indicate that, on average, companies are purchased at a premium to their market price, so it is arguable that the value of a company to a private owner is higher than the company’s market capitalization. (Location 521)
Toward the end of his life, Graham argued that even a genius would not be able to make money by studying company financial reports better and more deeply than his competitors. (Location 557)
Despite the disappearance of volumes of unjustifiably cheap stocks, interestingly, the scholars of finance observed that investing in relatively cheaper shares still remains a strategy that can earn excess returns. (Location 561)
Eventually, however, Buffett began to contemplate the handicaps associated with the method. At (Location 585)
Although he may have moved away from buying the cigar butts, and his experience has shown that cherry-picking from more expensive stocks produces the best results, (Location 588)
“Those two things together helped shift our thinking to the idea of paying higher prices for better businesses” (Location 600)
but at only six times annual profits—in today’s terms, a very modest price. (Location 602)
The company earned pretax profit of $75 million a year. (Location 604)
When calculating the margin of safety, the growth stock buyer relies on an expected earning power that is greater than the average shown in the past. (Location 622)
He remarked that there was no reason to think that carefully estimated future earnings should be a less reliable basis than the record of the past. (Location 624)
Discussing factors that may result in a share price rise, Graham mentions “investor expectations” with regard to profit growth. (Location 626)
Second, Graham believes that the core investment principles of a conservative investor must concentrate on the past and present position of the company. (Location 631)
companies and staying with them through all the fluctuations of a gyrating market proved far more profitable to far more people than did the more colourful practice of trying to buy them cheap and sell them dear” [Fisher, 1996, p. 7]. (Location 661)
He finds that over a sufficient time, for example, five years, the profit that even the most skilled statistical bargain hunter will create will be only a small proportion of the profit generated by an investor who is reasonably evaluating well-managed growth companies. (Location 663)
Fisher cites another reason why he finds growth companies attractive: growth stocks are superior not only in terms of capital appreciation, but also, given a reasonable time, in terms of dividend yield [Fisher, 1996, p. 60]. (Location 668)
Fisher suggests investing in more established companies while following his recommended principles (we examine these later in the chapter). (Location 672)
He reminds investors that growth can destroy value if monetary injections are required in the early years of the project or company, and these exceed the future cash flow. (Location 675)
In Fisher’s view: “Since a decline of 40 to 50 per cent from its peak is not at all uncommon for even the best stock in a normal business depression, is not completely ignoring the business cycle rather a risky policy?” [Fisher, 1996, p. 74]. According to Fisher, it is reasonable (Location 683)
When describing an attractive business, Buffett does not go as deeply into detail—after all, he is not writing a textbook, or perhaps he views a sustainable competitive advantage, which we discuss in the next chapter, as a considerably more important concept. (Location 723)
In Fisher’s view, all of a company’s profit may be used to finance its growth only at early stages of company development. (Location 736)
must pay out 25 to 40 percent of their profit as dividends (Location 738)
Fisher thought that dividends are a signal that a company can sustain and develop its business without consuming all its profit. (Location 738)
Fisher also writes that it is better to improve one’s understanding of companies than to reduce the risks that result from lack of knowledge by diversification. (Location 749)
when asked to explain what compels undervalued shares to grow in price, Graham remarked: (Location 755)
The textile industry also “illustrates in textbook style how producers of relatively undifferentiated goods in capital intensive businesses must earn inadequate returns except under conditions of tight supply or real shortage. (Location 833)
The capital employed not only does not earn a return, but also does not reinstate itself. (Location 836)
As a result, in the 1950s, the company began to encounter economic difficulties. In 1955, Berkshire Hathaway shares cost $14 a share. By 1962, the price had fallen to less than $8 a share, while the company’s working capital amounted to $16.50 a share. When the share price of a business is less than 50 percent of its working capital, this indicates that the market believes that the company will “consume” its current assets. (Location 847)
Berkshire’s competitors were implementing the same types of capital expenditures, and once a certain proportion of the industry participants had made these investments, the reduced cost base in the industry would have resulted in a reduction in prices. (Location 854)
“In a business selling a commodity-type product, it’s impossible to be a lot smarter than your dumbest competitor,” (Location 869)
If your competitors set prices at a level that is lower than your production costs, then you also must set prices at that level and suffer the losses if you are to remain in business. (Location 871)
this is only possible in a fantasy, for “most high-return businesses need relatively little capital” [Buffett, (Location 891)
Buffett opines that between two “wonderful” businesses one should choose the least capital intensive. (Location 893)
Buffett sold his investments in Kaiser Aluminum and Alcoa in 1980 and explained his decision by saying that the long-term performance of these companies would be more affected by the future economics of the aluminum industry than it would be by the direct operating decisions that management makes (Location 899)
Buffett does not believe in buying businesses in which success is possible only if all the employees involved are excellent (Location 912)
paraphrase Buffett, it may be as difficult “to be a lot smarter than your” smartest, as opposed to “dumbest competitor.” (Location 921)
although he also commented that most managers overestimated their abilities in this area. (Location 925)
He tried to look for princes disguised as toads, but all the princes that he invested in had been princes prior to the acquisition, while those that were toads at the time of his investment did not become princes regardless of how much he kissed them. As he put it, he kissed and they croaked. Thereafter he (Location 926)
the industry also has good aspects in that it is one of the few industries in which large lump sums are received up front, of which most, with good management, are retained; (Location 974)
A perfect investment is a business that functions like a money printing press. (Location 990)
Businesses that generate stable cash flows exist. Buffett calls such a business an economic franchise. (Location 991)
This is a variation of “the winner-takes-all” outcome in my view. (Location 1022)
They “possess large amounts of enduring goodwill” and “utilize a minimum (Location 1033)
of tangible assets” (Location 1033)
The test of a franchise is what a smart guy with a lot of money could do to it if he tried. If you gave me a billion dollars, and you gave me first draft pick of fifty business managers throughout the United States, (Location 1048)
Let us remember that Buffett believes that true franchises cannot be destroyed by poor management, as we discussed at the start of this section. (Location 1057)
Marlboro was because using Gillette razor blades and not buying the cheapest blades to avoid “an uncomfortable experience” would cost only $11 more a year [Berkshire Hathaway Annual Shareholders’ Meeting, 1993]. (Location 1102)
In the opinion of Robert Wiggins and Timothy Ruefli, who wrote “Sustained Competitive Advantage: Temporal Dynamics and the Incidence and Persistence of Superior Economic Performance” (Location 1132)
As criteria for success, they chose two measures: an accounting one (return on assets, or ROA) and a market one (Tobin’s q, the ratio of the firm’s market value to the replacement cost of its assets). (Location 1135)
NetJets’ model allowed for relatively low capital intensity. (Location 1162)
It may be that this is why Buffett considered this business attractive, as a high return on capital was possible in conditions of low operational profitability. (Location 1166)
In a young, rapidly growing industry, all companies are likely to be successful. (Location 1184)
The business model was no longer as perfect as it had seemed. (Location 1186)
Using the airplanes of a single manufacturer would have made it easier to train pilots and control the costs of service delivery. (Location 1188)
In his annual letter to shareholders in 2007, Buffett admitted that over the 10 years that Berkshire had owned NetJets, the company on the whole had generated losses, and the total loss amounted to $212 million [Buffett, 1977–2013, 2007]. (Location 1199)
Finally, Buffett admitted that NetJets would have ended up in bankruptcy had it not been for Berkshire’s deep pockets [Berkshire Hathaway, March 30, 2011]. (Location 1205)
In the end, Buffett’s competitors shut down their paper. Having acquired the local monopoly position, Buffett raised the prices for advertisers. (Location 1258)
According to some unconfirmed indications, which have not been discussed widely in public, the Buffalo Evening News did not publish a Sunday edition prior to its acquisition by Warren Buffett because of an informal agreement about the division of the market between the families that owned the two papers. (Location 1264)
The sale of the paper may have been a way to restructure the business and abandon personal obligations that could have been construed as unprofitable. (Location 1268)
Katharine Graham later talked about why the Star did not survive. (Location 1276)
For a considerable period of time, the loss-making business was subsidized by what is still the firm’s cash cow, the Kaplan Company, which was acquired in 1984. (Location 1338)
Successful investing is not about assessing the extent to which a certain industry will affect society, or how much it will grow, but about understanding the competitive advantage of any given company and correctly evaluating the durability of that advantage. (Location 1414)
Successful investing requires finding a business with excellent fundamentals or, better still, a business that is also an economic franchise. It is also desirable that this business be simple, understandable, and predictable, and that it does not depend on fast-changing technologies. It is also important that the business is run by an excellent management team (even though the business must be idiot-proof). (Location 1433)
Buffett added: “If you can’t write an essay describing ‘why I’m going to buy the entire company at the current valuation,’ you have no business buying 100 shares of stock” (Location 1544)
Charlie Munger points out, that “The game of investing is one of making better predictions about the future than other people. How are you going to do that? One way is to limit your tries to areas of competence. If you try to predict the future of everything, you attempt too much. You’re going to fail through lack of specialization” (Location 1549)
Once, in 2003, Buffett remarked that he is “generally familiar” with 1,700 or 1,800 American companies [Buffett, 2003]. (Location 1565)
In later years, he studied approximately 20 annual reports a week, or around 1,000 a year. (Location 1569)
He studied this new (for him) business area, then made acquisitions in the industry, but through a company for which this business area was primary. We review examples of this later in the chapter. (Location 1588)
The managers of the acquired company are the carriers of valuable information about which companies in their industry they consider as having good prospects. (Location 1658)
For instance, Buffett’s purchase of the Dexter Shoe Company, which specialized in shoe manufacturing, in 1993 was not successful. (Location 1681)
Indeed, we are willing to hold a stock indefinitely so long as we expect the business to increase in intrinsic value at a satisfactory rate” (Location 1703)
Buffett insists that he never attempts “to make money on the stock market.” (Location 1726)
In his view, one “could be somewhere where the mail was delayed three weeks and do just fine investing” [Grant, 1994, p. 58]. (Location 1728)
It aids in negotiations with family business owners. (Location 1748)
In practice, this principle is not something that Buffett follows dogmatically. (Location 1749)
“It always amazes me how high-IQ people mindlessly imitate. I never get good ideas talking to other people,” Buffett tells us [cited in Grant, 1994]. If this is not always true, then it is almost always true. (Location 1761)
Buffett comments that people are interested in stocks when their prices are high or too high, but prices are too high because human psychology makes them so. The (Location 1767)
In Buffett’s view, to be a successful investor, it is not sufficient to have an appropriate education. To be able to distinguish between a good and a bad business, it is necessary to have an intuition. (Location 1785)
Have the purchase price be so attractive that even a mediocre sale gives good results” (Location 1793)
“History teaches us that a crisis often causes problems to correlate in a manner undreamed of in more tranquil times” [Buffett 1977–2013, 2002]. (Location 1957)
Despite the fund’s spectacular collapse, the opinions expressed at the time were that just on the basis of that one precedent, it would have been premature to decide that the use of sophisticated financial modeling for these kinds of investment decisions would be unjustified in the future. (Location 1968)
Buffett’s insurance business generates leverage for Berkshire, but its levels of leverage, as calculated by analysts, are nowhere near as high. (Location 1978)
A large bet was made, among others, on the merger of two telecom companies, when difficulties associated with the deal were being widely discussed in the press and analysts were warning that the deal was likely to not materialize. (Location 2023)
Buffett believes that the market is populated by nonrational agents who act like lemmings (animals with great herd instincts) and who can all dash in one direction or another, with each of them using the behavior of the majority as her guide to action. (Location 2027)
always maintains a high level of liquidity. (Location 2032)
This introduced the idea that the future would be the same as the past. (Location 2050)
In reality, the returns are almost normally distributed—the distribution of returns is a Normal distribution–like bell-curve but it has “fat” tails. (Location 2056)
In his view, it is a matter of being approximately right rather then precisely wrong. (Location 2082)
Buffett, with all his affection for simple and predictable business attempted to buy what could be described as the remains of the fund when its management was preparing to announce the fund’s failure. (Location 2110)
Lynch, like Buffett, seeks to find companies that have strong fundamentals, or that have a monopoly or quasi-monopoly position, which is even better. (Location 2161)
As a rule of thumb, a stock should sell at or below the growth rate of its earnings. (Location 2182)
Both Lynch and Buffett prefer to invest in companies that do not depend on capital investment [Lynch and Rothchild, 2000, p. 214]. (Location 2195)
continuous capital investment has undermined many major manufacturers—for instance, a steel company may have a $1 billion turnover, but on a cost base of $950 million [Lynch and Rothchild, 2000, p. 228]. (Location 2197)
but a chain of donut franchises in New England is not going to lose business when somebody opens a superior donut franchise in Ohio. (Location 2202)
It is possible that Buffett and Lynch dislike the sector because of its dependence on macroeconomic conditions, given that both Buffett and Lynch consider the macroeconomic environment to be unpredictable. (Location 2216)
He looks for historical confirmation of past good results. (Location 2224)
“The greatest advantage to investing in stocks, to one who accepts the uncertainties, is the extraordinary reward for being right” [Lynch and Rothchild, 2000, p. 76]. (Location 2265)
“The risks have more to do with the investors than with the categories” [Lynch and Rothchild, (Location 2267)
risk is the result of the investor’s not being sufficiently thorough in his research. (Location 2268)
The typical big winner in Lynch’s portfolio took three to ten years or more to play out [Lynch and Rothchild, 2000, p. 12]. (Location 2270)
“My friend Warren Buffett and I”—Charlie Munger says—“entered the business world to find huge, predictable patterns of irrationality. (Location 2368)
Given that markets are irrational, predicting what the market will do in the short term is extremely difficult, if not impossible. Therefore, one should not engage in forecasting. (Location 2411)
As we have discussed, since the market is not always rational, it is possible to make money by finding companies that are not valued correctly, or, in other words, by making investments that are relatively risk-free, (Location 2443)
Since for Buffett risk arises from an investor’s misjudging his circle of competence, the task is not to take on risk, but to elude it. (Location 2448)
he is seeking someone who is “genetically” engineered to sense and avoid serious risk, even a risk which has never been encountered before (Location 2451)
“I would rather be certain of a good result than hopeful of a great one” (Location 2456)
Figure out business you understand, and concentrate. (Location 2467)
Following Keynes, Philip Fisher, and Gerald Loeb, Buffett finds that diversification is likely to be difficult to achieve because of the relative rarity of good investments. (Location 2474)
then I really think that if you can find six or eight of those, well that’s plenty,” (Location 2479)
Buffett did not want to become someone who betrayed the expectations of others. (Location 2534)
As we discussed, the ideal investment, in Buffett’s view, is a company that is able to use the maximum amount of capital at the highest possible return. (Location 2560)
a business that is able to deliver a high return. The second type is, of course, preferable. (Location 2561)
is the rate of return on the reinvested funds. (Location 2576)
“While deals often fail in practice, they never fail in projections” (Location 2641)
“The smarter side to take in a bidding war is the losing side,” argues Buffett [cited in Curran, 1993]. (Location 2645)
Often the acquirer’s managers overestimate their managerial ability, and the motivation for the acquisition is the illusion that they will be able to have the acquisition target generate more value than the original managers could. (Location 2664)
which considers the search for synergies a reasonable motivation for an M&A transaction. (Location 2683)
buys businesses that have high profitability potential, but he does not integrate them into his existing businesses; instead, he leaves them with operational independence. (Location 2684)
involved. He was not looking for synergies. Almost anyone else in his place would have chosen one CEO and let the other three go. (Location 2689)
“I bought four freestanding, well-managed furniture companies; don’t screw it up. Just keep running your companies like you do. I’ve got no objection to your meeting together and loving each other and so forth. But don’t look for synergy for my sake” [cited in Miles, 2002, p. 207]. (Location 2690)
Financial synergy means that leveraged financing becomes cheaper for small and medium companies once they become part of a large, diversified holding company whose cash flows are more stable and whose credit rating is higher. (Location 2701)
We discussed earlier how this story has developed—the existence of financial synergy may have been critical to the firm’s survival. (Location 2705)
The company was sold to Buffett precisely because he guaranteed financing on good terms. (Location 2713)
who talk about creating value for shareholders, in reality do not create value but transfer it from society to the shareholders. (Location 2747)
For the organizer of an LBO, of course, value may indeed be created. (Location 2751)
Munger criticizes the social aspects of these transactions, but he is compelled to accept that they often have an understandable rationale (Location 2754)
In Munger’s view, this is another factor that drives the price inflation during the acquisition process. (Location 2758)
the fund’s managing company receives a considerable part of the profit. (Location 2758)
This is what distinguishes him from other investors, who, particularly in the case of LBOs, receive not only a share of the profit proportional to their invested funds, but also the managing commission. (Location 2761)
the market also likes growing companies, and this creates an incentive to acquire other companies, even if they are overvalued. (Location 2768)
This is, in Munger’s words, “patient” capital that allows management to pursue long-term strategies [Lowe, 2000, p. 177]. (Location 2770)
Santulli explained his position by saying that he did not wish to be told how to run his business by a 28-year-old analyst. Santulli viewed Buffett as a long-term player who would not be concerned with the next three or six months [Miles, 2002, p. 124]. (Location 2793)
In the early stages of developing his insurance business, Buffett preferred to invest in publicly traded companies so that his assets were sufficiently liquid in case the need for large payouts arose. (Location 2801)
While in the earlier years, the share of liquid assets on Berkshire’s balance sheet could reach 90 percent, today it does not exceed 30 percent. (Location 2803)
Buffett mostly buys companies that could be described as cash cows, which do not need to raise new capital often, if at all, and if additional capital is required, then it can be found on Berkshire’s internal capital marketplace, where the cash of the diversified company is allocated. (Location 2805)
First, the manager has to run the business as if he owned 100 percent of it. Second, each manager must make decisions as if this business were the only asset that he or his family will ever have. Third, the business is not to be sold or merged “for at least a century” [Buffett, 1977–2013, 1998]. (Location 2811)
First, when Buffett buys a company from a CEO who will stay on as a manager or from her family, that seller is typically able to retain 10 to 12 percent of the company. (Location 2845)
a proportion of the shares of the company that Berkshire is acquiring is bought by the hired managerial staff. (Location 2847)
Their stakes cannot be revalued, so they have to be responsible for their actions. These managers became true owners [Buffett, 1977–2013, 2001]. (Location 2852)
The base salary is relatively low in comparison to the bonus part of the compensation package, as Buffett comments that “managers eager to bet heavily on their abilities usually have plenty of ability to bet on” [Buffett, 1977–2013, 1991]. (Location 2853)
The primary task, as we discussed, is earning a high return on capital. (Location 2856)
For this reason, the size of a manager’s compensation, as a rule, depends on the return on the invested capital. (Location 2859)
but to the growth of the company’s profit. (Location 2863)
If the profit grew by 16 percent a year over the course of five years (after the acquisition in 1999), then Sokol would receive $37.5 million; otherwise, he would receive nothing. (Location 2863)
Nevertheless, it seems, on the basis of Buffett’s letters to Berkshire’s shareholders, that these conditions were met. (Location 2866)
Returning capital to the holding company, of course, reduces the amount of capital left in the subsidiary and helps to maximize the return on the capital used in the business (this affects the manager’s compensation, as we discussed), while the subsidiary manager also receives the dividend payment through his ownership stake. (Location 2875)
Buffett does not see the value in increasing the number of independent directors on the boards of public companies, as it is required by the Sarbanes-Oxley Act, since, in Buffett’s view, an individual who is receiving 100 percent of his income from director’s fees and who may wish to enhance his income by being elected to other boards is not truly independent [Buffett, 2004a]. (Location 2891)
Buffett believes that shareholders should be in charge of protecting their own interests. (Location 2895)
The list compilers criticized Berkshire’s board for being small and family-oriented, and having no real outside directors [Kilpatrick, 2005, p. 288]. (Location 2900)
He felt that since it was he who cut the cake, it was only appropriate that he would get the last slice. (Location 2910)
The world has long since departed from the time when the manager and the owner of a business were one and the same and where there were no internal conflicts within this aggregate persona. (Location 2915)
Conservatively projected free cash flow covered interest payments and reductions in debt. (Location 2957)
prices paid for the acquired businesses became so high that all free cash flow had to be used for the payment of interest. (Location 2959)
If a company has a high level of leverage, then the smallest change for the worse in the operational results of the business may push it over the brink. (Location 2983)
A large amount of debt attached to a company may be viewed as a helpful tool from the point of view of the disciplining effect that the debt may have on the company’s managers. (Location 2985)
Buffett seeks out businesses that are able to deliver a high return on invested capital without relying on leverage to boost those returns. (Location 2993)
After the purchase of a company, Buffett recommends that the acquired company reduce and gradually end its relationship with its bank. (Location 2996)
Berkshire Hathaway pays considerable attention not only to the searching for good investments, but also to optimizing its capital structure. (Location 3001)
As estimated by Andrea Frazzini, David Kabiller, and Lasse Pedersen, the share of leverage in Berkshire’s capital structure amounted on average to approximately 37.5 percent from 1976 to 2011 (Location 3003)
It is precisely the use of leverage that is one of the key components of his phenomenal success. (Location 3006)
This also happens to be the company’s main business. Insurance theoretically does not require borrowing. (Location 3007)
By collecting premiums, the insurance company acquires capital that it can invest. (Location 3009)
The cash raised is “stored” and managed, or invested, until the expiration of the insurance contract and after. (Location 3062)
Insurance float as a portion of the total liabilities represented 36 percent. (Location 3067)
float is considered to be the ratio of the difference between payouts made and premiums raised in a given year to the (Location 3069)
This negative or extremely low cost of float would have been impossible if Berkshire had not radically reduced its presence in the market during years in which conditions were difficult. (Location 3085)
Buffett nevertheless seems to be successful at timing the catastrophe insurance business. (Location 3088)
Pulling away from the market in difficult years is encouraged by the company’s employee compensation schemes. (Location 3105)
The rest of the employees in Berkshire Hathaway’s insurance companies are not motivated to grow the business at any cost because they are not afraid of being fired during tougher times. (Location 3106)
He prefers to carry additional personnel costs rather than facing the large losses that may arise from a drive to write as many policies as possible without optimizing the return on capital. (Location 3108)
Comparing his approach to insurance business management with common industry practices, Buffett observes that most insurers would find it impossible to replicate Berkshire’s managerial mindset. (Location 3112)
“To avoid pink slips, employees will rationalize inadequate pricing, telling themselves that poorly priced business must be tolerated in order to keep the organization intact.” (Location 3118)
From the point of view of society as a whole, the en masse issuance of derivatives by the financial community generates leverage and increases the money supply, if indirectly. The (Location 3148)
The use of credit derivatives by financial institutions contributes to cycles of leveraging and deleveraging in an economy. Derivatives inherently create an effect that destabilizes the financial system. It becomes more volatile. (Location 3152)
When writing derivative contracts,12 Buffett attempts to correct for the shortcomings of the Black-Scholes model, which is traditionally used to value derivatives. (Location 3158)
He finds that the formula works less well over long intervals because in the long term, the volatility does not influence the price of the option as much as it does in the short term. (Location 3160)
that the price of an option on a stock or equity index, for instance, does not depend on its fair level. (Location 3162)
Hates? Not at all! He understands, loves, and uses derivatives with considerable success. So far, it looks as if Buffett will be the winning party in this last deal that we discussed. (Location 3205)
states that Nebraska Furniture Mart brought Berkshire Hathaway approximately $3.8 million of net profit. (Location 3279)
The profitability of a company becomes apparent to noninsiders only after a year. (Location 3282)
$14.5 million of profit before tax on turnover of $115 million [Buffett, 1977–2013, 1984]. (Location 3283)
The pretax profit margin of 12.6 percent is a very strong performance for a discount retail business. (Location 3284)
The store achieved high profitability through low operating expenses, which were half as high as those of comparable American companies. (Location 3285)
The enterprise value/EBIT1 multiplier at which the company was purchased would have amounted to 4.8. (Location 3290)
He observed the vast crowds jostling at the merchandise counters and wondered whether Berkshire was the only public company in the world that succeeded in earning a profit from its annual meetings [Matthews, 2009, p. 149]. (Location 3434)
If we subtract the conservative estimate of cash reserves of $14 from the share price, then we arrive at something that is just over five times the annual profits. (Location 3467)
The first two acquisitions highlight Buffett’s skills as a very patient judge of human nature and his ability to drive profitability through his personal brand. The last acquisition is an instance of Buffett’s acting as a fine tactician. (Location 3542)
The story of the acquisition of Scott Fetzer brings us to the topic of strategic positioning by Buffett in the market of mergers and acquisitions and the significance of this positioning in accessing potentially promising deals. (Location 3548)
Having examined the situation, Buffett concluded that the working capital was being misused. He fired the CEO and put a manager he trusted in charge of the business.1 (Location 3586)
Today Buffett is one of the most friendly investors toward the management of the companies that he buys. He never undertakes any hostile actions with respect to businesses that are of interest to him, and he always stands by the promises he makes before the deal. (Location 3612)
below those that would be achievable on the open market. (Location 3618)
When an owner exhibits a lack of interest in the business’s future, it is possible that the company has been dressed up for sale, especially if the seller is a financial investor. (Location 3624)
“If you have to go through too much investigation, something is wrong” (Location 3627)
One of the brothers later observed in an interview: “It’s a new concept in business. It’s called trust” (Location 3640)
“The economics are irrelevant if you don’t have trust” (Location 3642)
He would simply seek to find people who genuinely love their businesses (Location 3644)
Buffett stopped the practice of personally visiting the companies that he was buying. (Location 3645)
In one of his letters to shareholders, Buffett advises them that Berkshire has and will have no one—family members or recently recruited MBAs—to whom it has promised a chance to run a business that it has bought from owner-managers [Buffett, 1977–2013, 1990]. (Location 3650)
Managers left only to retire, and they retired at a very advanced age [Buffett, 1977–2013, 2001]. (Location 3653)
who may wish to sell the business that they have built to a “worthy” buyer through arrangements that are as painless as possible from a tax liability standpoint, (Location 3662)
Buffett, understanding this dilemma, offers the original owners the opportunity to continue to manage the business. (Location 3663)
The concept draws the kind of people who are able to create an excellent business in the first place and then are ready to sell it at a price that is less than the maximum achievable because they value a broader range of parameters, such as the character of the incoming buyer and the future of their business. (Location 3665)
The company’s condition turned out to be much worse than expected. (Location 3683)
He did not have that much time left in his life to invest his personal funds—a substantial sum that he, as a cofounder of MidAmerican Energy, had received after that company’s sale to Buffett. (Location 3712)
Berkshire’s internal investigation concluded that Sokol had not apprised Buffett of the size of his position in Lubrizol with sufficient clarity. (Location 3714)
“With almost every one of the companies Berkshire owns, I think I would do something different if I was running them—in some cases, substantially different” [cited in Bianco, 1999]. (Location 3724)
If managers of subsidiaries need Buffett’s help in managing the enterprise, “probably both” are “in trouble” [cited in Kilpatrick, 2005, p. 1380]. (Location 3727)
The only requirements are that the subsidiaries report their performance results and coordinate two types of decision at the conglomerate level: substantial capital expenditures and changes to their postresignation compensation packages. (Location 3730)
Buffett believes that in running businesses, “the best results come from letting high-grade people work unencumbered” (Location 3733)
This policy creates a level of comfort for the original owners, who have a habit of making independent decisions. (Location 3735)
Buffett’s position could have been described as, “I am buying it, but you are running it.” (Location 3740)
When asked whether Buffett’s company was an acquirer of choice, Rooney remarked that being part of Buffett’s organization is “the next best thing to being in business for yourself” (Location 3746)
eight times the annual profit, on revenue of $240 million and pretax profit of $24 million [Miles, 2002, p. 171]. (Location 3748)
if Buffett disagrees with the decision that is being taken, he does not interfere with the running of operations of companies where he is only a shareholder and a member of the board of directors. (Location 3752)
“He sells the incredible features and benefits of Berkshire ownership, and that attracts the willingness of like-minded owners and other good companies to be part of the Berkshire family” (Location 3763)
“He creates the image of ownership without having it, and that’s hard to do.” (Location 3765)
This made him feel that he would not take risks that were greater than those that he would have wanted to carry personally. (Location 3767)
Buffett, being a good judge of people, is aware that “the guy’s killing himself working for Warren” [Schloss, 1998]. (Location 3774)
He personally controlled all expenses, including those on pencil sharpeners. (Location 3779)
Buffett personally supervised the use of working capital. He demanded that the shipment of goods to those who had not yet settled their previous bills be suspended. (Location 3781)
Buffett was annoyed, although this was a small investment for him. “Even in a venture that couldn’t possibly make a buck, he needed that yardstick” of financial statements being sent out [Lowenstein, 1996, p. 145]. (Location 3790)
He introduced compensation packages for his CEOs that motivated them to reduce expenses and maximize their return on capital. (Location 3793)
When Buffett owned just a few companies, he had the time to evaluate the capital expenditures at all his subsidiaries personally. (Location 3796)
bonuses to his CEOs when his investment portfolio was relatively young because he wanted to accumulate cash for further investment. (Location 3797)
The hands-off approach is useful in yet another way. As we discussed in some detail in Chapter 3, Buffett invites the CEOs of Berkshire’s subsidiaries to look for suitable companies to buy. (Location 3813)
Although he did not want to sell the company, Child was nevertheless interested in researching the possibility of a sale. (Location 3835)
Child felt that he could not sell the company without the buyer having seen it. They debated the subject for a few minutes, and finally Buffett said that he was going to stop by while he was on his way to play golf with Bill Gates in Palm Springs (Location 3846)
Expressing admiration for an entrepreneur’s work may have helped Buffett to sell an unsuccessful investment. (Location 3856)
Weill offered Buffett $9 billion. Buffett found this offer satisfactory. “Ever diplomatic, Buffett praised Weill as a ‘genius’ at building shareholder value. (Location 3861)
The board would have welcomed Buffett, but he was already serving on a number of boards, including Salomon’s, which was a competitor of Shearson. Buffett’s calendar would already have been full [Kilpatrick, 2005, p. 854]. (Location 3901)
Spinning off Lehman undoubtedly made American Express’s shares more attractive. (Location 3916)
Engaging in other kinds of investing might disturb his preferred niche. (Location 3931)
In fact, Buffett does make money on hostile takeovers, but mostly as a neutral participant. (Location 3934)
but stopped the acquisition process at the request of the controlling manager-owner. (Location 3937)
Buffett acted simultaneously in all three capacities—friend, confidant, and expert advisor. (Location 3955)
In essence, Buffett was invited to walk in through the wide-open gate after he had declared that he was not going to climb over the fence. (Location 3957)
The family found that “fortunately” Buffett did not disagree with them when they felt particularly strongly about doing something, but that Buffett materially “influenced” their opinions on valuations. (Location 3960)
It is in Buffett’s style to offer a view on price, but not to comment directly on whether an acquisition is worthwhile. (Location 3972)
But he never—ever—made suggestions” (Location 3974)
Perhaps Buffett has achieved his extraordinary investment success precisely because his strategy is very complex. (Location 3984)
As we have discussed, Buffett is not a financial investor because he will not sell the acquired asset. (Location 4031)
He created a market niche: a “home” for mature companies whose owners wish to convert their business assets into a liquid form. (Location 4035)
The type of buyer is most important “if the sellers’ business represents the creative work of a lifetime and forms an integral part of their personality and sense of being” [Buffett, 1977–2013, (Location 4039)
The owners wanted to withdraw capital from the enterprise, but they also wanted to retain a small stake and continue exercising operational control. (Location 4043)
Fechheimer had pretax earnings of $8.4 million. Buffett bought it at a valuation of $55 million [Buffett, 1977–2013, 1986], or at a price to pretax earnings multiple of 6.1. (Location 4046)
Forward-looking entrepreneurs sell their businesses when they still have the energy and interest to remain in charge, rather than near the natural end of their professional life. (Location 4060)
The business has to be sold at a time when the new owners are in constrained circumstances. (Location 4065)
From a tax point of view, a sale through a merger is better still, as the business is “sold” in exchange for shares of another company and the sale is not subject to capital gains tax. (Location 4067)
He would never finance a transaction through borrowing and use the acquired shares as collateral, nor would he borrow against the acquired assets after a transaction. (Location 4096)
Buffett began acting in the capacity of a “white knight” at the end of the 1980s, when LBO-style acquisitions became fashionable. (Location 4217)
These purchases were financed mainly through issuing junk bonds. (Location 4218)
In negotiations with Buffett, after the seller states her price, Buffett makes his final decision and does not review it, even if the seller reduces the price in response. (Location 4282)
when he was still building the backbone of his “money printing press” by buying companies, delivering return on capital, and accumulating insurance businesses, a tough negotiating stance was not always appropriate. (Location 4303)
Buffett exercises great care in transactions where the procedure requires an auction, as is the law in bankruptcy cases. (Location 4342)
He always tries to convert the auction into an exclusive transaction, for instance, with the help of high breakup fees. (Location 4343)
Buffett only shot back that, in his view, the book value was not correct and advised that broker to examine how cement plants sold in the last several years (Location 4651)
found that Buffett would always manage to bring up details from some annual report that would prove important and that Byrne had forgotten or missed entirely (Location 4653)
He had received some materials about the company prior to the seller’s visit, and it was apparent that Buffett had a very clear understanding of the data that had been sent to him. (Location 4656)
Buffett develops and maintains his “knowledge database.” (Location 4664)
“When that phone rings [this is a phone call from a business owner who is looking to sell his company], he usually knows the economics of the business (he has already analyzed every company that fits his acquisition criteria). (Location 4666)
Importantly, within “five minutes,” Buffett lets the person know only whether or not he is potentially interested. (Location 4668)
In essence, Buffett is an intelligence agency, in as much as an investment company. (Location 4670)
never went back to high-tech mode. I tried it once and found it to have many problems. I was like Mark Twain’s cat that, after a bad experience, never again sat on a hot stove or on a cold stove either” [cited in Lowe, 2000, p. 59]. (Location 4719)
One’s acquaintances are always a channel for gathering information when it comes to both looking for investment opportunities and researching those that have presented themselves. (Location 4733)
This image of being a simple man ended up being of assistance not only in business, but also in political circles. (Location 4809)
Structuring his investment vehicle as a joint stock company permitted him to use the insurance business as the foundation stone for the whole edifice. (Location 4844)
Therefore, he was in a position to guarantee that he would not sell his shares under any circumstances. (Location 4863)
Second, Buffett has guaranteed a friendly attitude. (Location 4866)
The unique combination of a friendly investor with a great reputation who can promise specific conduct toward companies in which he invests has led to his acquisition of a considerable number of valuable minority stakes, many of which were a defense against nonfriendly takeovers. (Location 4867)
First, Buffett is able to pay 100 percent of the purchase price in cash. Second, the seller has Buffett’s assurance that once he has made an offer, the deal will take place on precisely the terms that were offered. (Location 4880)