An owner’s manual
Warren Buffett explained his principles of operation in his Owner’s Manual to Berkshire Hathaway’s shareholders in 1999. More than just a manual for his shareholders, it’s become somewhat of a timeless primer for managers, business owners and investors to read, revisit and emulate. Given it was written more than two decades ago, we decided to review Buffett’s philosophy for our own notebook. This post will condense his owner-related business principles, alongside a few classic Mungerisms.
Our attitude is partnership
“View a stock as an ownership of the business and judge the staying quality of the business in terms of its competitive advantage.”
Charlie Munger
Warren Buffett does not view Berkshire Hathaway as the sole owner of business assets, but as a “conduit” for shareholders to own the assets. Likewise, he doesn’t want his shareholders to think of themselves as mere owners of stock certificates. Instead, they should visualise themselves as part-owner of the business, much in the same way we might own a house, farm or family partnership.
We eat our own cooking
“Everywhere there is a large commission, there is a high probability of a rip-off.”
Charlie Munger
Berkshire Hathaway operates on an owner oriented model. Warren himself had more than 99% of his net-worth invested in Berkshire at the time of writing (1999). He is comfortable with this “eggs-in-one-basket” approach because Berkshire invests in “truly extraordinary businesses” for the long-term.
Owner-oriented managers are less likely to enrich themselves at the expense of shareholders when their financial gain and suffering is proportional to their shareholders. They’re also less likely to engage in dubious expansions or acquisitions at the shareholder’s expense and company’s long-term health. Ownership and good compensation schemes incentivise managers to treat shareholder capital in the same way they’d handle their own money.
Managing Berkshire Hathaway
“I don’t think in [the] history of the world has anything [of] Berkshire’s size [been] organized in so decentralized a fashion.”
Charlie Munger
Berkshire’s operations are decentralised, with only 12 out of 45,000 people at headquarters (at the time of writing). Buffett and Munger give their managers full autonomy and responsibility for all operating decisions. This frees Warren and Charlie to focus on the redeployment of capital from a greater vantage point, and the compensation schemes of their management teams. To deliver long-term value creation, succession planning is also important. Buffett is confident that the unannounced successors he has selected will carry on Berkshire’s principles.
Communicate what matters
“The CEO who misleads others in public may eventually mislead himself in private.”
Warren Buffett
Since accounting conventions and consolidated reports are not always reflective of economic reality, managers should communicate all the information that really matters to shareholders. Berkshire Hathaway believed in being as candid as possible, during good times and bad. Buffett’s guideline here is simple: tell shareholder the facts that you would like to know if your positions were reversed.
Teach and educate
Buffett feels strongly about sharing his business and investment philosophy with others. He describes the generosity of great teachers like Benjamin Graham, and feels it appropriate to share what he’s learned with others – even if this creates greater competition for Berkshire Hathaway. However, Buffett avoids the discussion of specific investment ideas itself. He describes the challenge of finding new ideas as quickly as Berkshire generates cash. As in business, great investment ideas are rare and susceptible to appropriation and replication.
One financial goal: maximise intrinsic value per share
Company size is not a measure of value creation or economic significance. It’s the growth in intrinsic business value per share that should matter most to owner-oriented managers and shareholders. Many companies will find it harder to grow intrinsic value per share as their capital base grows.
Own durable franchises
“When we bought See’s Candy, we didn’t know the power of a good brand. Over time, we just discovered that we could raise prices 10% a year and no one cared. Learning that changed Berkshire. It was really important.”
Charlie Munger
To achieve their financial goal, Berkshire’s strategy is to own a diversified group of cash-generative businesses that earn above-average returns on capital consistently. As described in his 1991 letter, these are usually economic franchises with products that: (1) customers desire or need; (2) have no comparable substitute; and (3) can raise prices over time. Buffett has noted for example how businesses in commodity markets rarely satisfy these requirements. Their returns on capital are often subject to phases of the industry cycle.
The one-dollar test
Buffett says that we should check noble intentions against actual results. Here, Berkshire Hathaway employs the one-dollar test: for every $1 that management retains; they should deliver at least $1 of market value to shareholders. Berkshire assesses this on a five-year rolling basis. Companies must use retained earnings wisely. For this reason, Berkshire is also extra cautious against major capital outlays in poor performing businesses in declining industries.
Economics, not accounting
Accounting consequences do not influence Berkshire’s operating and capital allocation decisions. Their focus is on the maximisation of long-term intrinsic value, and not quarterly results. For example, Buffett highlights how he prefers $2 of acquisitive earnings, that are not reportable under standard accounting principles, to $1 of reportable earnings. Similarly, Berkshire doesn’t engage in creative accounting, massive restructures, result smoothing, scorecard gaming or earnings guidance. They tell it like it is, and focus on the knowable and controllable for long-term value creation.
Use debt sparingly
“We’re happier with less leverage… Missing out on some opportunity never bothers us. What’s wrong with someone getting a little richer than you? It’s crazy to worry about this.”
Charlie Munger
Buffett will reject investment opportunities if it might over-leverage Berkshire’s balance sheet. While such conservatism can hurt results, it is the responsible thing to do for long-term shareholders (many families invest their entire savings in Berkshire) and policyholders (Berkshire’s fiduciary obligations as an insurance company). Likewise, Berkshire is careful about equity issuances (e.g. common stock, stock options, etc.). Managers must generate at least as much business value as they give away. Otherwise, you are just transferring value from one owner to the next.
Fortunately, Berkshire has access to two sources of low-cost ‘leverage’. The first is the tax deferred liability that stems from a low portfolio turnover rate. The second is Berkshire’s access to insurance float – their insurance premium liability prior to future payment. However, neither sources of leverage are cost-free. The former relies on careful stock selection and capital allocation, while the latter depends also on conservative and disciplined insurance underwriting.
Avoid gin rummy behaviour
“Sit on your ass investing. You’re paying less to brokers, you’re listening to less nonsense, and if it works, the tax system gives you an extra one, two, or three percentage points per annum.”
Charlie Munger
Perhaps the most contentious of Berkshire’s philosophy is their reluctance to sell good businesses, regardless of price. They’re also reluctant to sell sub-par businesses if they remain cash generative and operate with decent managers and labour relations. Again, this speaks to their focus on long-term ownership and partnerships. Their preference is to pay for and stick with high quality companies at reasonable prices. So, the goal is to avoid mistakes in capital allocation and stock selection in the first place.
Resist the institutional imperative
“If you’re not willing to react with equanimity to a market price decline of 50% two or three times a century you’re not fit to be a common shareholder”
Charlie Munger
Berkshire is wary of mindless imitation in business and investing, particularly during markets of extreme euphoria or pessimism. Unlike many investors, Berkshire Hathaway views depressed stock markets as a wellspring of opportunity for two reasons. Firstly, depressed stock markets make the purchase price of wonderful companies more affordable. Secondly but similarly, businesses that Berkshire already owns are able to repurchase their own shares at larger discounts. As Buffett once said, be “fearful when others are greedy, and greedy when others are fearful.”
Comments on intrinsic value
Remember that intrinsic value is the discounted value of future cash flows that shareholders can take out of a business during its life. While imprecise, uncertain and sensitive to future conditions (e.g. interest rates), Buffett believes that intrinsic value is the only logical concept for evaluating the relative attractiveness of businesses and investments.
Book value
Berkshire Hathaway also reports the percentage change in book value per share. However, Buffett describes it as an imperfect indicator of change in intrinsic value per share. While book value is easy to compute and accounts for holdings in marketable securities carried at current prices, it does not account for the intrinsic value of companies under direct control. For example, assets carried at cost may not reflect the total improvement in cash generative potential of high-quality companies.
EBITDA
“I think that, every time you see the word EBITDA, you should substitute the word ‘bulls**t earnings’.”
Charlie Munger
Buffett also warns against the use of EBITDA (earnings before interest, taxes, depreciation and amortization) as a measure of company performance. In most cases, depreciation reflects a very real economic cost to the company. Focusing only on EBITDA may translate to poor investment choices.
The Berkshire model in practice
The operating principles of Berkshire Hathaway describe a common-sense approach to business, management and investing. While simple to understand, it’s not always easy to observe in other companies or replicate in one’s investment practice. But Buffett does offer more guidance in his annual letters to shareholders. What follows is a quick rundown.
Recognising franchises
Buffett emphasises the importance of investing in companies you understand, have a consistent track record and demonstrate favourable long-term prospects. Books like Bruce Greenwald’s Competition Demystified or Pat Dorsey’s The Little Book That Builds Wealth may offer additional support. Ultimately, spotting durable economic franchises rests on your ability to recognise and understand the demand, supply and/or scale advantages that a company may / may not enjoy.
Evaluating management
The Oracle of Omaha has also expressed his preference for investing in rational, candid and competent managers that can resist the institutional imperative. While capital allocation, insider ownership and compensation plans are important signals, you may also have to rely on qualitative judgements. In Investing Between the Lines, LJ Rittenhouse recommends investors scrutinise executive candour on vision, strategy, accountability, relationships and capital stewardship to inform this.
Calculating intrinsic value
Finally, Buffett will only purchase businesses or their stock at or below his estimate of intrinsic value. The larger this margin of safety, the better. Remember that Warren Buffett’s goal is to buy wonderful companies at fair prices. Books like Bruce Greenwald’s Value Investing: From Graham to Buffett and Beyond offer great insights and case studies on estimating the intrinsic value of companies. Other titles like Robert Hagstrom’s The Warren Buffett Way provide a nice distillation of Buffett’s business, management, financial and value tenets to investing.
Berkshire’s legacy
Warren Buffett has been the Pole Star in investing for this last half century. He and Charlie Munger will leave an enduring legacy in Berkshire Hathaway in which their likely successors, Ajit Jain and Greg Abel, will carry forward. These investors are a rare breed, and we should not expect to replicate the returns they have achieved. However, with study and hard work, we can hope to apply some of their principles with moderate success over the long-term at least. After all, the Berkshire model is a rational, honest and fun way to do business. Buffett himself still tap dances to work every morning.
Further reading
- Buffett, W. (1999). Berkshire Hathaway, An Owner’s Manual. Available at <https://www.berkshirehathaway.com/owners.html>
- Buffett, W. Annual Letters to Shareholders. Available at <https://www.berkshirehathaway.com/letters/letters.html>
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- The Warren Buffett Way – Robert Hagstrom on Buffett’s investment tenets
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- Bruce Greenwald on Value Investing, From Graham to Buffett and Beyond
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