This principle may seem obvious, but we constantly see it violated. And, when misallocations occur, shareholders are hurt. For example, in contemplating business mergers and acquisitions, many managers tend to focus on whether the transaction is immediately dilutive or antidilutive to earnings per share or, at financial institutions, to per-share book value.
An emphasis of this sort carries great dangers… Imagine that a year-old first-year M. The M. But what could be sillier for the student than a deal of this kind? At Berkshire, we have rejected many merger and purchase opportunities that would have boosted current and near-term earnings but reduced per-share intrinsic value. That happens because the acquirer typically gives up more intrinsic value than it receives.
Almost by definition, a really good business generates far more money at least after its early years than it can use internally. The company could, of course, distribute the money to shareholders by way of dividends or share repurchases. But often the CEO asks a strategic planning staff, consultants, or investment bankers whether an acquisition or two might make sense.
The acquisition problem is often compounded by a biological bias: Many CEOs attain their positions in part because they possess an abundance of animal spirits and ego. When such a CEO is encouraged by his advisers to make deals, he responds much as would a teenage boy who is encouraged by his father to have a normal sex life.
Some years back, a CEO friend of mine—in jest, it must be said—unintentionally described the pathology of many big deals. This friend, who ran a property-casualty insurer, was explaining to his directors why he wanted to acquire a certain life insurance company. After droning rather unpersuasively through the economics and strategic rationale for the acquisition, he abruptly abandoned the script. When you are with Warren, you can tell how much he loves his work.
It comes across in many ways. We are quite candid and not at all adversarial. Warren stays away from technology companies because he likes investments in which he can predict winners a decade in advance—an almost impossible feat when it comes to technology.
Unfortunately for Warren, the world of technology knows no boundaries. One area in which we do joust now and then is mathematics. Once Warren presented me with four unusual dice, each with a unique combination of numbers from 0 to 12 on its sides.
He proposed that we each choose one of the dice, discard the third and fourth, and wager on who would roll the highest number most often. He graciously offered to let me choose my die first. You choose first. Once he chose a die, it took me a couple of minutes to figure out which of the three remaining dice to choose in response.
Because of the careful selection of the numbers on each die, they were nontransitive. Each of the four dice could be beaten by one of the others: die A would tend to beat die B, die B would tend to beat die C, die C would tend to beat die D, and die D would tend to beat die A. This meant that there was no winning first choice of a die, only a winning second choice. It was counterintuitive, like a lot of things in the business world.
Warren is great with numbers, and I love math, too. Warren never makes an investment where the difference between doing it and not doing it relies on the second digit of computation.
And you'd be right--those are both big reasons for Buffett's success. But he also has a character trait that has helped him stay on top in a rapidly changing world, and it's not one most business leaders value--he's willing to be wrong. In addition, he's willing to admit he's been wrong, something few leaders ever do.
What's even more important and more rare is that he's willing to rewrite his own rules--even rules that helped him succeed in the past--to adapt to changing times and new realities. Case in point: Apple. Berkshire Hathaway revealed this year that its single biggest investment is in Apple. Berkshire owns just over 5 percent of Apple, which makes up more than 40 percent of its U.
Buffett's been investing in the company for a few years now, which is interesting if you remember that for decades, the Oracle of Omaha famously avoided technology stocks. In fact, that was Rule Number 5 of Berkshire Hathaway's acquisition criteria : "Simple businesses if there's lots of technology, we won't understand it. About a decade ago, Buffett changed his mind about technology and began investing in IBM.
At the time, it was the most long-established and stable-seeming tech company he could have picked. He said he was impressed with the hold IBM appeared to have on its customers because switching IT providers would be challenging for most companies.
Determining this is inherently tricky. But evidently, Buffett is very good at it. One important point to remember about public companies is that the Securities and Exchange Commission SEC requires that they file regular financial statements. You might initially think of this question as a radical approach to narrowing down a company. Buffett, however, sees this question as an important one.
He tends to shy away but not always from companies whose products are indistinguishable from those of competitors, and those that rely solely on a commodity such as oil and gas. If the company does not offer anything different from another firm within the same industry, Buffett sees little that sets the company apart. Any characteristic that is hard to replicate is what Buffett calls a company's economic moat , or competitive advantage.
This is the kicker. Finding companies that meet the other five criteria is one thing, but determining whether they are undervalued is the most difficult part of value investing. And it's Buffett's most important skill. To check this, an investor must determine a company's intrinsic value by analyzing a number of business fundamentals including earnings, revenues, and assets.
And a company's intrinsic value is usually higher and more complicated than its liquidation value, which is what a company would be worth if it were broken up and sold today. The liquidation value doesn't include intangibles such as the value of a brand name, which is not directly stated on the financial statements. Once Buffett determines the intrinsic value of the company as a whole, he compares it to its current market capitalization —the current total worth or price.
Well, Buffett's success, however, depends on his unmatched skill in accurately determining this intrinsic value. While we can outline some of his criteria, we have no way of knowing exactly how he gained such precise mastery of calculating value.
As you've probably noticed, Buffett's investing style is like the shopping style of a bargain hunter. It reflects a practical, down-to-earth attitude.
Buffett maintains this attitude in other areas of his life: He doesn't live in a huge house, he doesn't collect cars, and he doesn't take a limousine to work.
The value-investing style is not without its critics, but whether you support Buffett or not, the proof is in the pudding.
Berkshire Hathaway. Accessed Sept. Giving Pledge. Haven Health Care. CS Investing. Mary Buffett and David Clark. Scribner, Robert Hagstrom. Wiley, Securities and Exchange Commission. Warren Buffett.
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