Amazon.com: The Essays of Warren Buffett: Lessons for Corporate America (9781611637588): Warren E. Buffett, Lawrence A. Cunningham: Books
I revisit the books that change my worldview and have a high potential for lasting impact.
By compiling the highlights and arranging them with context, I gradually hope to build a foundation of knowledge that endures with time and provides me, or anyone reading this, lasting value. Below are highlights from the most recent book that fit this criteria, titled The Essays of Warren Buffett: Lessons for Corporate America.
The requisites for board membership should be business savvy, interest in the job, and owner-orientation. Too often, directors are selected simply because they are prominent or add diversity to the board. That practice is a mistake. Furthermore, mistakes in selecting directors are particularly serious because appointments are so hard to undo: The pleasant but vacuous director need never worry about job security.
It's easy to make mistakes while appointing board members because performance standards for this job seldom exist. A CEO requires accountability and her bosses are the board of directors.
Amassing early losses in the textile business
I ignored Comte's advice—“ the intellect should be the servant of the heart, but not its slave”—and believed what I preferred to believe.
Should you find yourself in a chronically-leaking boat, energy devoted to changing vessels is likely to be more productive than energy devoted to patching leaks.
It is easy to become blind to rationality for even the most disciplined investor. Also we should be on guard to protect against the sunk cost fallacy.
Conventionality often overpowers rationality. John Maynard Keynes said in his masterful The General Theory. “Worldly wisdom teaches that it is better for reputation to fail conventionally than to succeed unconventionally.” (Or, to put it in less elegant terms, lemmings as a class may be derided but never does an individual lemming get criticized.) From a reputational standpoint, Charlie and I run a clear risk with our foreign-exchange commitment. But we believe in managing Berkshire as if we owned 100% of it ourselves. And, were that the case, we would not be following a dollar-only policy.
People feel more comfortable being wrong in a herd than being right independently. For the cost of latter when it goes wrong is perceived to be much higher.
Academic obsession over the precision of 'beta'–a way to measure risk
It is better to be approximately right than precisely wrong. For example, under beta-based theory, a stock that has dropped very sharply compared to the market—as had Washington Post when we bought it in 1973—becomes “riskier” at the lower price than it was at the higher price. In fact, the true investor welcomes volatility.
Value of dollar cost averaging
The investor should both own a large number of equities and space out his purchases. By periodically investing in an index fund, for example, the know-nothing investor can actually out-perform most investment professionals. Paradoxically, when 'dumb' money acknowledges its limitations, it ceases to be dumb.
Need for limiting trading activity
Nor do we think many others can achieve long-term investment success by flitting from flower to flower. Indeed, we believe that according the name “investors” to institutions that trade actively is like calling someone who repeatedly engages in one-night stands a romantic.
Higher tax rates and the friction of trading activity eats away the returns of most investor when they do earn a net positive return.
On Berkshire holding on to a small number of truly excellent businesses
And since finding great businesses and outstanding managers is so difficult, why should we discard proven products? Our motto is: “If at first you do succeed, quit trying.”
For the average passive investor though, with little or no knowledge, and time, low cost index funds are the best bet.
Compensation plan of public companies
It has become fashionable at public companies to describe almost every compensation plan as aligning the interests of management with those of shareholders. In our book, alignment means being a partner in both directions, not just on the upside. Many “alignment” plans flunk this basic test, being artful forms of “heads I win, tails you lose.”
A common form of misalignment occurs in the typical stock option arrangement, which does not periodically increase the option price to compensate for the fact that retained earnings are building up the wealth of the company.
Compensation should be tied to results. In the vast majority of companies, CEOs get a disproportionately favorable compensation compared to any other employee in the company, partly because employees are vastly incentivized to being agreeable to the one person who has no boss.
Also stock options as form of compensation is difficult to measure and is therefore ignored–at the expense of shareholders.
Rationality (or lack thereof) of only looking at the stock price to make a buy or sell decision
And the fact that a given asset as appreciated in the recent past is never a reason to buy it Games are won by those who're focussed on the playing field—not by those whose eyes are glued to the scoreboard
The price you pay for an asset is as important as the asset you get in return. Buying an asset when it appreciates in price makes it more expensive if the underlying business hasn't changed to justify the increase.
Dealing with the difficulties of evaluating equities
At Berkshire, we attempt to deal with this problem in two ways. First, we try to stick to businesses we believe we understand. Second, and equally important, we insist on a margin of safety in our purchase price. If we calculate the value of a common stock to be only slightly higher than its price, we're not interested in buying. We believe this margin-of-safety principle, so strongly emphasized by Ben Graham, to be the cornerstone of investment success.
The chips are stacked in favor of the investor. Avoiding bad mistakes is an excellent way to win big in the long term.
The risky nature of seemingly safe currency investments
Investments that are denominated in a given currency include money-market funds, bonds, mortgages, bank deposits, and other instruments. Most of these currency-based investments are thought of as “safe.” In truth they are among the most dangerous of assets. Their beta may be zero, but their risk is huge. Over the past century these instruments have destroyed the purchasing power of investors in many countries, even as the holders continued to receive timely payments of interest and principal. This ugly result, moreover, will forever recur. Governments determine the ultimate value of money, and systemic forces will sometimes cause them to gravitate to policies that produce inflation. From time to time such policies spin out of control. Even in the U.S., where the wish for a stable currency is strong, the dollar has fallen a staggering 86% in value since 1965, when I took over management of Berkshire. It takes no less than $7 today to buy what $1 did at that time. Consequently, a tax-free institution would have needed 4.3% interest annually from bond investments over that period to simply maintain its purchasing power.
Estimates about return on investment should factor the purchasing power of the appreciating asset and the enjoyment power of the depreciating asset (your body).
The best kinds of currency assets
Accommodating this need, we primarily hold U.S. Treasury bills, the only investment that can be counted on for liquidity under the most chaotic of economic conditions. Our working level for liquidity is $20 billion; $10 billion is our absolute minimum.
Although the catch here is the requirement to pay interest on unrealized gains.
Common causes of low prices for a stock
The most common cause of low prices is pessimism—sometimes pervasive, sometimes specific to a company or industry. We want to do business in such an environment, not because we like pessimism but because we like the prices it produces. It's optimism that is the enemy of the rational buyer. None of this means, however, that a business or stock is an intelligent purchase simply because it is unpopular; a contrarian approach is just as foolish as a follow-the-crowd strategy. What's required is thinking rather than polling. Unfortunately, Bertrand Russell's observation about life in general applies with unusual force in the financial world: “Most men would rather die than think. Many do.”
Following the herd is the best way to loose money in the stock market.
The risk of using historical patterns to predict future results
(Beware of past-performance “proofs” in finance: If history books were the key to riches, the Forbes 400 would consist of librarians.)
Correlation does not mean causation. Not realizing this simple truth has caused a great amount of misery in this world.
Expectations of shareholder returns
With unimportant exceptions, such as bankruptcies in which some of a company's losses are borne by creditors, the most that owners in aggregate can earn between now and Judgment Day is what their businesses in aggregate earn.
Consistent policy for dividends
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.
Any equity stake based on a formulaic policy for dividend returns is dogmatic.
Difference between investment and speculation
The line separating investment and speculation, which is never bright and clear, becomes blurred still further when most market participants have recently enjoyed triumphs. Nothing sedates rationality rationality like large doses of effortless money. After a heady experience of that kind, normally sensible people drift into behavior akin to that of Cinderella at the ball. They know that overstaying the festivities—that is, continuing to speculate in companies that have gigantic valuations relative to the cash they are likely to generate in the future—will eventually bring on pumpkins and mice. But they nevertheless hate to miss a single minute of what is one helluva party. Therefore, the giddy participants all plan to leave just seconds before midnight. There's a problem, though: They are dancing in a room in which the clocks have no hands.
During inflation, Goodwill is the gift that keeps giving.
But is also difficult to measure.
It has been far safer to steal large sums with a pen than small sums with a gun.
In authority we trust–the motto of our education system, leading to irrational decisions causing incalculable harm.
Benefits of delayed taxes
Through my favorite comic strip, Li'l Abner, I got a chance during my youth to see the benefits of delayed taxes, though I missed the lesson at the time. Making his readers feel superior, Li'l Abner bungled happily, but moronically, through life in Dogpatch. At one point he became infatuated with a New York temptress, Appassionatta Van Climax, but despaired of marrying her because he had only a single silver dollar and she was interested solely in millionaires. Dejected, Abner took his problem to Old Man Mose, the font of all knowledge in Dogpatch. Said the sage: Double your money 20 times and Appassionatta will be yours (1, 2, 4, 8 . . . . 1,048,576). My last memory of the strip is Abner entering a roadhouse, dropping his dollar into a slot machine, and hitting a jackpot that spilled money all over the floor. Meticulously following Mose's advice, Abner picked up two dollars and went off to find his next double. Whereupon I dumped Abner and began reading Ben Graham. Mose clearly was overrated as a guru: Besides failing to anticipate Abner's slavish obedience to instructions, he also forgot about taxes. Had Abner been subject, say, to the 35% federal tax rate that Berkshire pays, and had he managed one double annually, he would after 20 years only have accumulated $22,370. Indeed, had he kept on both getting his annual doubles and paying a 35% tax on each, he would have needed 7½ years more to reach the $1 million required to win Appassionatta. But what if Abner had instead put his dollar in a single investment and held it until it doubled the same 27½ times? In that case, he would have realized about $200 million pre-tax or, after paying a $70 million tax in the final year, about $130 million after-tax. For that, Appassionatta would have crawled to Dogpatch. Of course, with 27½ years having passed, how Appassionatta would have looked to a fellow sitting on $130 million is another question.
Simple math goes a long way in generating extraordinary wealth.
If horses had controlled investment decisions, there would have been no auto industry. If the divesting company later wishes to reacquire If the divesting company later wishes to reacquire the spun-off operation, it presumably would again be urged by its bankers to pay a hefty “control” premium for the privilege. (Mental “flexibility” of this sort by the banking fraternity has prompted the saying that fees too often lead to transactions rather than transactions leading to fees.)
People respond to incentives.
Safety and conservatism of Berkshire
I believe the chance of any event causing Berkshire to experience financial problems is essentially zero. We will always be prepared for the thousand-year flood; in fact, if it occurs we will be selling life jackets to the unprepared. Berkshire played an important role as a “first responder” during the 2008-2009 meltdown, and we have since more than doubled the strength of our balance sheet and our earnings potential. Your company is the Gibraltar of American business and will remain so. The reason for our conservatism, which may impress some people as extreme, is that it is entirely predictable that people will occasionally panic, but not at all predictable when this will happen. Though practically all days are relatively uneventful, tomorrow is always uncertain. (I felt no special apprehension on December 6, 1941 or September 10, 2001.) And if you can't predict what tomorrow will bring, you must be prepared for whatever it does.
Berkshire's continued long term success or lack thereof
• The bad news is that Berkshire's long-term gains—measured by percentages, not by dollars—cannot be dramatic and will not come close to those achieved in the past 50 years. The numbers have become too big. I think Berkshire will outperform the average American company, but our advantage, if any, won't be great. Eventually—probably between ten and twenty years from now—Berkshire's earnings and capital resources will reach a level that will not allow management to intelligently reinvest all of the company's earnings. At that time our directors will need to determine whether the best method to distribute the excess earnings is through dividends, share repurchases or both. If Berkshire shares are selling below intrinsic business value, massive repurchases will almost certainly be the best choice. You can be comfortable that your directors will make the right decision.
The law of large numbers.
Book recommendations and mentions
For a terrific discussion on mutual funds — John Bogle’s Common Sense on Mutual Funds.
In The Theory of Investment Value, written over 50 years ago, John Burr Williams set forth the equation for value, which we condense here: The value of any stock, bond or business today is determined by the cash inflows and outflows–discounted at an appropriate interest rate–that can be expected to occur during the remaining life of the asset.
In our view, though, investment students need only two well-taught courses—How to Value a Business, and How to Think About Market Prices.
John Maynard Keynes's masterful The General Theory.
Benjamin Graham's The Intelligent Investor: The Definitive Book on Value Investing.
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